Chapter 10 The Basics of Capital Budgeting Evaluating Cash Flows

ANSWERS T EN!" F"C#A$TER %&EST' NS

10-1

a. Capital budgeting is the whole process of analyzing projects and deciding whether they should be included in the capital budget. This process is of fundamental importance to the success or failure of the firm as the fixed asset investment decisions chart the course of a company for many years into the future. The paybac ! or paybac period! is the number of years it ta es a firm to recover its project investment. "aybac may be calculated with either raw cash flows #regular paybac $ or discounted cash flows #discounted paybac $. %n either case! paybac does not capture a project&s entire cash flow stream and is thus not the preferred evaluation method. 'ote! however! that the paybac does measure a project&s li(uidity! and hence many firms use it as a ris measure. b. )utually exclusive projects cannot be performed at the same time. *e can choose either "roject 1 or "roject +! or we can reject both! but we cannot accept both projects. %ndependent projects can be accepted or rejected individually. c. The net present value #'",$ and internal rate of return #%--$ techni(ues are discounted cash flow #.C/$ evaluation techni(ues. These are called .C/ methods because they explicitly recognize the time value of money. '", is the present value of the project&s expected future cash flows #both inflows and outflows$! discounted at the appropriate cost of capital. '", is a direct measure of the value of the project to shareholders. The internal rate of return #%--$ is the discount rate that e(uates the present value of the expected future cash inflows and outflows. %-- measures the rate of return on a project! but it assumes that all cash flows can be reinvested at the %-- rate. d. The modified internal rate of return #)%--$ assumes that cash flows from all projects are reinvested at the cost of capital as opposed to the project&s own %--. This ma es the modified internal rate of return a better indicator of a project&s true profitability. The profitability index is found by dividing the project0s ", of future cash flows by its initial cost. 1 profitability index greater than 1 is e(uivalent to a positive '", project. e. 1n '", profile is the plot of a project&s '", versus its cost of capital. The crossover rate is the cost of capital at which the '", profiles for two projects intersect.

Answers and Solutions: 10 " 1

f. Capital projects with nonnormal cash flows have a large cash outflow either sometime during or at the end of their lives. 1 common problem encountered when evaluating projects with nonnormal cash flows is multiple %--s. 1 project has normal cash flows if one or more cash outflows #costs$ are followed by a series of cash inflows. g. The hurdle rate is the project cost of capital! or discount rate. %t is the rate used in discounting future cash flows in the '", method! and it is the rate that is compared to the %--. The mathematics of the '", method imply that project cash flows are reinvested at the cost of capital while the %-- method assumes reinvestment at the %--. 2ince project cash flows can be replaced by new external capital which costs r! the proper reinvestment rate assumption is the cost of capital! and thus the best capital budget decision rule is '",. The post-audit is the final aspect of the capital budgeting process. The post-audit is a feedbac process in which the actual results are compared with those predicted in the original capital budgeting analysis. The postaudit has several purposes! the most important being to improve forecasts and improve operations. h. 1 replacement chain is a method of comparing mutually exclusive projects that have une(ual lives. 3ach project is replicated such that they will both terminate in a common year. %f projects with lives of 4 years and 5 years are being evaluated! the 4year project would be replicated 5 times and the 5-year project replicated 4 times6 thus! both projects would terminate in 15 years. 'ot all projects maximize their '", if operated over their engineering lives and therefore it may be best to terminate a project prior to its potential life. The economic life is the number of years a project should be operated to maximize its '",! and is often less than the maximum potential life. Capital rationing occurs when management places a constraint on the size of the firm0s capital budget during a particular period. 10-+ "roject classification schemes can be used to indicate how much analysis is re(uired to evaluate a given project! the level of the executive who must approve the project! and the cost of capital that should be used to calculate the project&s '",. Thus! classification schemes can increase the efficiency of the capital budgeting process. The '", is obtained by discounting future cash flows! and the discounting process actually compounds the interest rate over time. Thus! an increase in the discount rate has a much greater impact on a cash flow in 7ear 5 than on a cash flow in 7ear 1. This (uestion is related to 9uestion 10-4 and the same rationale applies. *ith regard to the second part of the (uestion! the answer is no6 the %-- ran ings are constant and independent of the firm&s cost of capital.

10-4

10-8

Answers and Solutions: 10 " (

10-5

The '", and %-- methods both involve compound interest! and the mathematics of discounting re(uires an assumption about reinvestment rates. The '", method assumes reinvestment at the cost of capital! while the %-- method assumes reinvestment at the %--. )%-- is a modified version of %-- which assumes reinvestment at the cost of capital. ;enerally! the failure to employ common life analysis in such situations will bias the '", against the shorter project because it <gets no credit< for profits beyond its initial life! even though it could possibly be <renewed< and thus provide additional '",.

10-:

Answers and Solutions: 10 " )

S *&T' NS T

EN!" F"C#A$TER $R B*E+S

10-1

a. =5+!1+5>=1+!000 ? 8.484@! so the paybac is about 8 years. b. "roject A&s discounted paybac period is calculated as followsB "eriod 0 1 + 4 8 5 : E @ 1nnual Cash /lows #=5+!1+5$ 1+!000 1+!000 1+!000 1+!000 1+!000 1+!000 1+!000 1+!000 .iscounted C1+D Cash /lows #=5+!1+5.00$ 10!E18.@0 F!5::.80 @!581.:0 E!:+:.00 :!@0@.@0 :!0EF.+0 5!8+E.:0 8!@8:.@0
=+!E@@.+0

Cumulative #=5+!1+5.00$ #81!810.+0$ #41!@84.@0$ #+4!40+.+0$ #15!:E:.+0$ #@!@:E.80$ #+!E@@.+0$ +!:4F.80 E!8@:.+0

The discounted paybac period is : G =5!8+E.:0 years! or :.51 years. 1lternatively! since the annual cash flows are the same! one can divide =1+!000 by 1.1+ #the discount rate ? 1+D$ to arrive at C/ 1 and then continue to divide by 1.1+ seven more times to obtain the discounted cash flows #Column 4 values$. The remainder of the analysis would be the same. c. '", ? -=5+!1+5 G =1+!000H#1>i$-#1>#iI#1Gi$n$J ? -=5+!1+5 G =1+!000H#1>0.1+$-#1>#0.1+I#1G0.1+$@$J ? -=5+!1+5 G =1+!000#8.F:E:$ ? =E!8@:.+0. /inancial calculatorB %nput the appropriate cash flows into the cash flow register! input % ? 1+! and then solve for '", ? =E!8@:.:@. d. /inancial calculatorB %nput the appropriate cash flows into the cash flow register and then solve for %-- ? 1:D.

Answers and Solutions: 10 " ,

e. )%--B ", Costs ? =5+!1+5. /, %nflowsB ", 012%

|

1
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+
|

4
|

8
|

5
|

:
|

E
|

/, @
|

1+!000

5+!1+5

1+!000 1+!000 1+!000 1+!000 1+!000 1+!000 1+!000 14!880 15!054 1:!@5F 1@!@@+ +1!18@ +4!:@: +:!5+@ )%-- ? 14.@FD 18E!5F:

/inancial calculatorB Kbtain the /,1 by inputting ' ? @! % ? 1+! ", ? 0! ")T ? 1+000! and then solve for /, ? =18E!5F:. The )%-- can be obtained by inputting ' ? @! ", ? -5+1+5! ")T ? 0! /, ? 18E5F:! and then solving for % ? 14.@FD. 10-+ "roject 1B Lsing a financial calculator! enter the followingB C/0 ? -15000000 C/1 ? 5000000 C/+ ? 10000000

Answers and Solutions: 10 " -

C/4 ? +0000000 % ? 106 '", ? =1+!@4:!+14. Change % ? 10 to % ? 56 '", ? =1:!10@!F5+. Change % ? 5 to % ? 156 '", ? =10!05F!5@E. "roject MB Lsing a financial calculator! enter the followingB C/0 ? -15000000 C/1 ? +0000000 C/+ ? 10000000 C/4 ? :000000 % ? 106 '", ? =15!F58!1E0. Change % ? 10 to % ? 56 '", ? =1@!400!F4F. Change % ? 5 to % ? 156 '", ? =14!@FE!@4@.

10-4

Truck: '", ? -=1E!100 G =5!100#",%/118D!5$ ? -=1E!100 G =5!100#4.8441$ ? -=1E!100 G =1E!50F ? =80F. #1ccept$

Answers and Solutions: 10 " .

/inancial calculatorB %nput the appropriate cash flows into the cash flow register! input % ? 18! and then solve for '", ? =80F. /inancial calculatorB %nput the appropriate cash flows into the cash flow register and then solve for %-- ? 18.FFD N 15D. )%--B ", Costs ? =1E!100. /, %nflowsB ", 0 18D
|

1
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+
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4
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8
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/, 5
|

5!100

5!100

5!100

5!100

1E!100

)%-- ? 18.58D #1ccept$

5!100 5!@18 :!:+@ E!55: @!:18 44!E1+

/inancial calculatorB Kbtain the /,1 by inputting ' ? 5! % ? 18! ", ? 0! ")T ? 5100! and then solve for /, ? =44!E1+. The )%-- can be obtained by inputting ' ? 5! ", ? -1E100! ")T ? 0! /, ? 44E1+! and then solving for % ? 18.58D. Pulley: '", ? -=++!840 G =E!500#4.8441$ ? -=++!840 G =+5!E8@ ? =4!41@. #1ccept$ /inancial calculatorB %nput the appropriate cash flows into the cash flow register! input % ? 18! and then solve for '", ? =4!41@. /inancial calculatorB %nput the appropriate cash flows into the cash flow register and then solve for %-- ? +0D. )%--B ", Costs ? =++!840.

Answers and Solutions: 10 " /

/, %nflowsB ", 0 18D

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1
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+
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4
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8
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/, 5
|

E!500

E!500

E!500

E!500

++!840

)%-- ? 1E.1FD #1ccept$

E!500 @!550 F!E8E 11!11+ 1+!::E 8F!5E:

/inancial calculatorB Kbtain the /,1 by inputting ' ? 5! % ? 18! ", ? 0! ")T ? E500! and then solve for /, ? =8F!5E:. The )%-- can be obtained by inputting ' ? 5! ", ? -++840! ")T ? 0! /, ? 8F5E:! and then solving for % ? 1E.1FD. 10-8 Electric-powered: '",3 ? -=++!000 G =:!+F0 H#1>i$-#1>#iI#1Gi$n$J ? -=++!000 G =:!+F0 H#1>0.1+$-#1>#0.1+I#1G0.1+$:$J ? -=++!000 G =:!+F0#8.1118$ ? -=++!000 G =+5!@:1 ? =4!@:1. /inancial calculatorB %nput the appropriate cash flows into the cash flow register! input % ? 1+! and then solve for '", ? =4!@:1. /inancial calculatorB %nput the appropriate cash flows into the cash flow register and then solve for %-- ? 1@D. Gas-powered: '",; ? -=1E!500 G =5!000 H#1>i$-#1>#iI#1Gi$n$J ? -=1E!500 G =5!000 H#1>0.1+$-#1>#0.1+I#1G0.1+$:$J ? -=1E!500 G =5!000#8.1118$ ? -=1E!500 G =+0!55E ? =4!05E. /inancial calculatorB %nput the appropriate cash flows into the cash flow register! input % ? 1+! and then solve for '", ? =4!05E. /inancial calculatorB %nput the appropriate cash flows into the cash flow register and then solve for %-- ? 1E.FED N 1@D. The firm should purchase the electric-powered for lift because it has a higher '", than the gas-powered for lift. The company gets a high rate of return #1@D O r ? 1+D$ on a larger investment.

Answers and Solutions: 10 " 0

10-5

/inancial calculator solution! '",B Project S %nputs 5

'

1+
% ",

4000
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0
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Kutput

? -10!@18.44 '",2 ? =10!@18.44 - =10!000 ? =@18.44.

Project L %nputs 5
'

1+
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E800
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0
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Kutput

? -+:!:E5.48 '",P ? =+:!:E5.48 - =+5!000 ? =1!:E5.48.

/inancial calculator solution! %--B %nput C/0 ? -10000! C/1 ? 4000! 'j ? 5! %--2 ? Q %--2 ? 15.+8D. %nput C/0 ? -+5000! C/1 ? E800! 'j ? 5! %--P ? Q %--P ? 18.:ED. /inancial calculator solution! )%--B Project S %nputs 5
'

1+
%

0
",

4000
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Kutput ", costs2 ? =10!000. /, inflows2 ? =1F!05@.58. %nputs 5

' %

? -1F!05@.58

-10000
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1F05@.58
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Kutput

? 14.EE )%--2 ? 14.EED. Answers and Solutions: 10 " 1

Project L %nputs 5
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1+
%

0
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E800
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Kutput ? -8E!011.0E ", costsP ? =+5!000. /, inflowsP ? =8E!011.0E. %nputs 5

' %

-+5000
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0
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8E011.0E
/,

Kutput

? 14.8: )%--P ? 14.8:D.

"%2 ?

=10!@18.44 =+:!:E5.48 ? 1.0@1. "% ? 1.0:E. P ? =10!000 =+5!000

Thus! '",P O '",2! %--2 O %--P! )%--2 O )%--P! and "%2 O "%P. The scale difference between "rojects 2 and P result in the %--! )%--! and "% favoring 2 over P. Rowever! '", favors "roject P! and hence P should be chosen.

Answers and Solutions: 10 " 10

10-:

"roject SB

0 1+D
|

1
|

+
|

4
|

8
|

-1!000

100

400

800

E00.00 88@.00 4E:.4+ 180.8F 1!::8.@1

1!000

14.5FD ? )%--ST

=1!000 ? =1!::8.@1>#1 G )%--S$8. "roject 7B 0 1+D

| -1!000

1
|

+
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4
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8
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1!000

100

50

50.00 5:.00 1+5.88 1!808.F4 1!:4:.4E

1!000

14.10D ? )%--7

=1!000 ? =1!:4:.4E>#1 G )%--7$8. Thus! since )%--S O )%--7! "roject S should be chosen. 1lternative stepB 7ou could calculate '",s! see that "roject S has the higher '",! and just calculate )%--S. '",S ? =5@.0+ and '",7 ? =4F.F8. 10-E a. "urchase price %nstallation %nitial outlay = F00!000 1:5!000 =1!0:5!000

C/0 ? -10:50006 C/1-5 ? 4500006 % ? 186 '", ? Q '", ? =14:!5E@6 %-- ? 1F.++D. b. %gnoring environmental concerns! the project should be underta en because its '", is positive and its %-- is greater than the firm&s cost of capital. c. 3nvironmental effects could be added by estimating penalties or any other cash outflows that might be imposed on the firm to help return the land to its previous state #if possible$. These outflows could be so large as to cause the project to have a negative '",--in which case the project should not be underta en.

Answers and Solutions: 10 " 11

10-@

a.
NPV ($)
1,000 900 800 700 600 500 00 !00 "00 100

Project A

Project B Cost of Capital (%)

5 10 15 "0 "5 !0

#100 #"00 #!00

r 0.0D 10.0 1+.0 1@.1 +0.0 +8.0 40.0

'",1 =@F0 +@4 +00 0 #8F$ #14@$ #+4@$

'",M =4FF 1EF 18: :+ 81 0 #51$

b. %--1 ? 1@.1D6 %--M ? +8.0D. Answers and Solutions: 10 " 1(

c. 1t r ? 10D! "roject 1 has the greater '",! specifically =+@4.48 as compared to "roject M&s '", of =1E@.:0. Thus! "roject 1 would be selected. 1t r ? 1ED! "roject M has an '", of =E5.F5 which is higher than "roject 1&s '", of =41.05. Thus! choose "roject M if r ? 1ED. d. Rere is the )%-- for "roject 1 when r ? 10DB ", costs ? =400 G =4@E>#1.10$1 G =1F4>#1.10$+ G =100>#1.10$4 G =1@0>#1.10$E ? =FE@.@+. T, inflows ? =:00#1.10$4 G =:00#1.10$+ G =@50#1.10$1 ? =+!85F.:0. 'ow! )%-- is that discount rate which forces the T, of =+!85F.:0 in E years to e(ual =FE@.@+B =F5+.00 ? =+!58E.:0#1G)%--$E. )%--1 ? 18.0ED. 2imilarly! )%--M ? 15.@FD. 1t r ? 1ED! )%--1 ? 1E.5ED. )%--M ? 1F.F1D. e. To find the crossover rate! construct a "roject U which is the difference in the two projects& cash flowsB "roject U ? 7ear C/1 - C/M 0 =105 1 #5+1$ + #4+E$ 4 #+48$ 8 8:: 5 8:: : E1: E #1@0$ %--U ? Crossover rate ? 18.54D. "rojects 1 and M are mutually exclusive! thus! only one of the projects can be chosen. 1s long as the cost of capital is greater than the crossover rate! both the '", and %-methods will lead to the same project selection. Rowever! if the cost of capital is less than the crossover rate the two methods lead to different project selections--a conflict exists. *hen a conflict exists the '", method must be used. Mecause of the sign changes and the size of the cash flows! "roject U has multiple %--s. Thus! a calculator&s %-- function will not work. Kne could use the trial and Answers and Solutions: 10 " 1)

error method of entering different discount rates until '", ? =0. Rowever! an R" can be <tric ed< into giving the roots. 1fter you have eyed "roject .elta&s cash flows into the g register of an R"-10M! you will see an <3rror-2oln< message. 'ow enter 10 2TK %-->7- and the 18.54D %-- is found. Then enter 100 2TK %-->7- to obtain %-- ? 85:.++D. 2imilarly! 3xcel or Potus 1-+-4 can also be used. 10-F a. 7ear 0 1 +-+0 "lan M #=10!000!000$ 1!E50!000 1!E50!000 "lan 1 #=10!000!000$ 1+!000!000 0 %ncremental Cash /low #M - 1$ = 0 #10!+50!000$ 1!E50!000

%f the firm goes with "lan M! it will forgo =10!+50!000 in 7ear 1! but will receive =1!E50!000 per year in 7ears +-+0. b. %f the firm could invest the incremental =10!+50!000 at a return of 1:.0ED! it would receive cash flows of =1!E50!000. %f we set up an amortization schedule! we would find that payments of =1!E50!000 per year for 1F years would amortize a loan of =10!+50!000 at 1:.0::5D. /inancial calculator solutionB %nputs 1F
' %

-10+50000
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1E50000
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0
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Kutput

? 1:.0::5

c. 7es! assuming #1$ e(ual ris among projects! and #+$ that the cost of capital is a constant and does not vary with the amount of capital raised. d. 2ee graph. %f the cost of capital is less than 1:.0ED! then "lan M should be accepted6 if r O 1:.0ED! then "lan 1 is preferred.
NPV ($illio%s of &ollars)
"5

"0

15

10

Crosso'er (ate ) 16*07%

A Answers and Solutions: 10 " 1,

5

+((B ) 16*7% +((A ) "0%

10

15

"0

"5

Cost of Capital (%)

10-10 a. /inancial calculator solutionB Plan A %nputs +0

'

10
% ",

@000000
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0
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Kutput Plan B %nputs +0

'

? -:@!10@!510 '",1 ? =:@!10@!510 - =50!000!000 ? =1@!10@!510. 10

% ",

4800000
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0
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Kutput

? -+@!F8:!11E '",M ? =+@!F8:!11E - =15!000!000 ? =14!F8:!11E.

Plan A %nputs +0
' %

-50000000
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@000000
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0
/,

Kutput

? 15.04 %--1 ? 15.04D.

Plan B %nputs +0
' %

-15000000
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4800000
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0
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Kutput

? ++.+: %--M ? ++.+:D.

Answers and Solutions: 10 " 1-

b. %f the company ta es "lan 1 rather than M! its cash flows will be #in millions of dollars$B Cash /lows Cash /lows "roject U 7ear from 1 from M Cash /lows 0 #=50$ #=15.0$ #=45.0$ 1 @ 4.8 8.: + @ 4.8 8.: . . . . . . . . . . . . +0 @ 4.8 8.: 2o! "roject U has a <cost< of =45!000!000 and <inflows< of =8!:00!000 per year for +0 years. %nputs +0
'

10
% ",

8:00000
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0
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Kutput ? -4F!1:+!4F4 '", ? =4F!1:+!4F4 - =45!000!000 ? =8!1:+!4F4. %nputs + -45000000 8:00000

' % ", ")T

0
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Kutput ? 11.E1 %-- ? 11.E1D. 2ince %--U O r! and since we should accept U. This means accept the larger project #"roject 1$. %n addition! when dealing with mutually exclusive projects! we use the '", method for choosing the best project.

Answers and Solutions: 10 " 1.

c.
NPV ($illio%s of &ollars)
1"5

A
100

Crosso'er (ate ) 11*7%

75

50

+((A ) 15*0!% +((B ) ""*"6%

"5

10

15

"0

"5

!0

Cost of Capital (%)

#"5

#50

+(( ) 11*7%

d. The '", method implicitly assumes that the opportunity exists to reinvest the cash flows generated by a project at the cost of capital! while use of the %-- method implies the opportunity to reinvest at the %--. %f the firm&s cost of capital is constant at 10 percent! all projects with an '", O 0 will be accepted by the firm. 1s cash flows come in from these projects! the firm will either pay them out to investors! or use them as a substitute for outside capital which costs 10 percent. Thus! since these cash flows are expected to save the firm 10 percent! this is their opportunity cost reinvestment rate. The %-- method assumes reinvestment at the internal rate of return itself! which is an incorrect assumption! given a constant expected future cost of capital! and ready access to capital mar ets.

Answers and Solutions: 10 " 1/

10-11 a. The project&s expected cash flows are as follows #in millions of dollars$B Time 'et Cash /low 0 #= 8.8$ 1 +E.E + #+5.0$ *e can construct the following '", profileB
NPV ($illio%s of &ollars)
!

$a,i-.NPV at 80*5%

"

&isco.%t (ate (%)

10 #1 "0 80*5 "0

+((1 ) 9*"%

+((" )

"0%

#"

#!

# # *

NPV approac/es #$ *0 as t/e cost of capital approac/es

.iscount -ate 0D F 10 50 100 +00 400 800 810 8+0 840

'", #=1!E00!000$ #+F!15:$ 1+0!::1 +!F55!55: 4!+00!000 +!055!55: F:+!500 180!000 E0!+08 +!4:E #:4!5@1$

Answers and Solutions: 10 " 10

The table above was constructed using a financial calculator with the following inputsB C/0 ? -8800000! C/1 ? +EE00000! C/+ ? -+5000000! and % ? discount rate to solve for the '",. b. %f r ? @D! reject the project since '", V 0. Mut if r ? 18D! accept the project because '", O 0. c. Kther possible projects with multiple rates of return could be nuclear power plants where disposal of radioactive wastes is re(uired at the end of the project&s life! or leveraged leases where the borrowed funds are repaid at the end of the lease life. #2ee Chapter +0 for more information on leases.$ d. Rere is the )%-- for the project when r ? @DB ", costs ? =8!800!000 G =+5!000!000>#1.0@$+ ? =+5!@44!8E0.51. T, inflows ? =+E!E00!000#1.0@$1 ? =+F!F1:!000.00. 'ow! )%-- is that discount rate which forces the ", of the T, of =+F!F1:!000 over + years to e(ual =+5!@44!8E0.51B =+5!@44!8E0.51 ? =+F!F1:!000#",%/r!+$. %nputs +
' %

-+5@448E0.51
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0
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+FF1:000
/,

Kutput )%-- ? E.:1D. 1t r ? 18D! %nputs +

'

? E.:1

-+4:4::@@.+1
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0
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415E@000
/,

Kutput

? 15.5@ )%-- ? 15.5@D.

", costs ? =8!800!000 G =+5!000!000>#1.18$+ ? =+4!:4:!:@@.+1. T, inflows ? =+E!E00!000#1.18$1 ? =41!5E@!000. Answers and Solutions: 10 " 11

'ow! )%-- is that discount rate which forces the ", of the T, of =41!5E@!000 over + years to e(ual =+4!:4:!:@@.+1B =+4!:4:!:@@.+1 ? =41!5E@!000#",%/r!+$. 7es. The )%-- method leads to the same conclusion as the '", method. -eject the project if r ? @D! which is greater than the corresponding )%-- of E.:1D! and accept the project if r ? 18D! which is less than the corresponding )%-- of 15.5@D. 10-1+ a. The %--s of the two alternatives are undefined. To calculate an %--! the cash flow stream must include both cash inflows and outflows. b. The ", of costs for the conveyor system is #=F11!0:E$! while the ", of costs for the for lift system is #=@4@!@48$. Thus! the for lift system is expected to be #=@4@!@48$ #=F11!0:E$ ? =E+!+44 less costly than the conveyor system! and hence the for lift truc s should be used. /inancial calculator solutionB %nputB C/0 ? -500000! C/1 ? -1+0000! 'j ? 8! C/+ ? -+0000! % ? @! '",C ? Q '",C ? -F11!0:E. %nputB C/0 ? -+00000! C/1 ? -1:0000! '1 ? 5! % ? @! '",/ ? Q '",/ ? -@4@!@48. 10-14 a. "aybac 1 #cash flows in thousands$B "eriod 0 1 + 4 8 "aybac
1

1nnual Cash /lows #=+5!000$ 5!000 10!000 15!000 +0!000

Cumulative #=+5!000$ #+0!000$ #10!000$ 5!000 +5!000

? + G =10!000>=15!000 ? +.:E years.

Answers and Solutions: 10 " (0

"aybac M #cash flows in thousands$B 1nnual "eriod Cash /lows 0 #=+5!000$ 1 +0!000 + 10!000 4 @!000 8 :!000 "aybac
M

Cumulative =+5!000$ #5!000$ 5!000 14!000 1F!000

? 1 G =5!000>=10!000 ? 1.50 years.

b. .iscounted paybac 1 #cash flows in thousands$B "eriod 0 1 + 4 8 1nnual Cash /lows #=+5!000$ 5!000 10!000 15!000 +0!000
1

.iscounted C10D Cash /lows Cumulative #=+5!000.00$ #=+5!000.00$ 8!585.85 # +0!858.55$ @!+:8.8: # 1+!1F0.0F$ 11!+:F.E+ # F+0.4E$ 14!::0.+E 1+!E4F.F0

.iscounted "aybac

? 4 G =F+0.4E>=14!::0.+E ? 4.0E years.

.iscounted paybac M #cash flows in thousands$B "eriod 0 1 + 4 8 1nnual .iscounted C10D Cash /lows Cash /lows #=+5!000$ #=+5!000.00$ +0!000 1@!1@1.@+ 10!000 @!+:8.8: @!000 :!010.5+ :!000 8!0F@.0@
M

Cumulative #=+5!000.00$ # :!@1@.1@$ 1!88:.+@ E!85:.@0 11!558.@@

.iscounted "aybac

? 1 G =:!@1@.1@>=@!+:8.8: ? 1.@+5 years.

c. '",1 ? =1+!E4F!F0@6 %--1 ? +E.+ED. '",M ? =11!558!@@06 %--M ? 4:.15D. Moth projects have positive '",s! so both projects should be underta en. d. 1t a discount rate of 5D! '",1 ? =1@!+84!@14. 1t a discount rate of 5D! '",M ? =18!F:8!@+F. 1t a discount rate of 5D! "roject 1 has the higher '",6 conse(uently! it should be accepted. Answers and Solutions: 10 " (1

e. 1t a discount rate of 15D! '",1 ? =@!+0E!0E1. 1t a discount rate of 15D! '",M ? =@!:84!4F0. 1t a discount rate of 15D! "roject M has the higher '",6 conse(uently! it should be accepted. f. 7ear 0 1 + 4 8 "roject U ? C/1 - C/M = 0 #15$ 0 E 18

%--U ? Crossover rate ? 14.5+58D N 14.54D. g. Lse 4 steps to calculate )%--1 C r ? 10DB 2tep 1B Calculate the '", of the uneven cash flow stream! so its /, can then be calculated. *ith a financial calculator! enter the cash flow stream into the cash flow registers! then enter % ? 10! and solve for '", ? =4E!E4F!F0@. 2tep +B Calculate the /, of the cash flow stream as followsB 3nter ' ? 8! % ? 10! ", ? -4EE4FF0@! and ")T ? 0 to solve for /, ? =55!+55!000. 2tep 4B Calculate )%--1 as followsB 3nter ' ? 8! ", ? -+5000000! ")T ? 0! and /, ? 55+55000 to solve for % ? +1.F4D. Lse 4 steps to calculate )%--M C r ? 10DB 2tep 1B Calculate the '", of the uneven cash flow stream! so its /, can then be calculated. *ith a financial calculator! enter the cash flow stream into the cash flow registers! then enter % ? 10! and solve for '", ? =4:!558!@@0. 2tep +B Calculate the /, of the cash flow stream as followsB 3nter ' ? 8! % ? 10! ", ? -4:558@@0! and ")T ? 0 to solve for /, ? =54!5+0!000. 2tep 4B Calculate )%--M as followsB 3nter ' ? 8! ", ? -+5000000! ")T ? 0! and /, ? 545+0000 to solve for % ? +0.F:D. Answers and Solutions: 10 " ((

1ccording to the )%-- approach! if the + projects were mutually exclusive! "roject 1 would be chosen because it has the higher )%--. This is consistent with the '", approach. 10-18 "lane 1B 1+D. "lane MB 0 1B
|

3xpected life ? 5 years6 Cost ? =100 million6 'C/ ? =40 million6 CKC ? 3xpected life ? 10 years6 Cost ? =14+ million6 'C/ ? =+5 million6 CKC ? 1+D. 1
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+
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4
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8
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5
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:
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E
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@
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F
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10
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-100

40

40

40

40

40 -100 -E0

40

40

40

40

40

3nter these values into the cash flow registerB C/ 0 ? -1006 C/1-8 ? 406 C/5 ? -E06 C/:10 ? 40. Then enter % ? 1+! and press the '", ey to get '", 1 ? 1+.E:8 =1+.E: million.

0 MB
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1
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+
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4
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8
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5
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:
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E
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@
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F
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10
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-14+

+5

+5

+5

+5

+5

+5

+5

+5

+5

+5

3nter these cash flows into the cash flow register! along with the interest rate! and press the '", ey to get '",M ? F.+5: N =F.+: million. "roject 1 is the better project and will increase the company&s value by =1+.E: million.

Answers and Solutions: 10 " ()

10-15 1B

0
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1
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+
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4
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8
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5
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:
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E
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@
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-10

8 -10 -:

)achine 1&s simple '", is calculated as followsB 3nter C/ 0 ? -10 and C/1-8 ? 8. Then enter % ? 10! and press the '", ey to get '", 1 ? =+.:EF million. Rowever! this does not consider the fact that the project can be repeated again. 3nter these values into the cash flow registerB C/0 ? -106 C/1-4 ? 86 C/8 ? -:6 C/5-@ ? 8. Then enter % ? 10! and press the '", ey to get 3xtended '", 1 ? =8.50F: N =8.51 million. 0 MB
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1
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+
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4
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8
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5
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:
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E
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@
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-15

4.5

4.5

4.5

4.5

4.5

4.5

4.5

4.5

3nter these cash flows into the cash flow register! along with the interest rate! and press the '", ey to get '",M ? =4.:E+ N =4.:E million. )achine 1 is the better project and will increase the company&s value by =8.51 million. 10-1: a. Lsing a financial calculator! input the followingB C/ 0 ? -1F0000! C/1 ? @E000! 'j ? 4! and % ? 18 to solve for '",1F0-4 ? =11!F@1.FF N =11!F@+ #for 4 years$. 1djusted '",1F0-4 ? =11!F@+ G =11!F@+>#1.18$4 ? =+0!0E0. Lsing a financial calculator! input the followingB C/ 0 ? -4:0000! C/1 ? F@400! 'j ? :! and % ? 18 to solve for '",4:0-: ? =++!+5:.0+ N =++!+5: #for : years$. Moth new machines have positive '",s! hence the old machine should be replaced. /urther! since its adjusted '", is greater! choose )odel 4:0-:.

Answers and Solutions: 10 " (,

10-1E a. '", of termination after 7ear tB '",0 ? -=++!500 G =++!500 ? 0. Lsing a financial calculator! input the followingB C/0 ? -++500! C/1 ? +4E50! and % ? 10 to solve for '",1 ? -=F0F.0F N -=F0F. Lsing a financial calculator! input the followingB C/ 0 ? -++500! C/1 ? :+50! C/+ ? +0+50! and % ? 10 to solve for '",+ ? -=@+.:8 N -=@4. Lsing a financial calculator! input the followingB C/ 0 ? -++500! C/1 ? :+50! 'j ? +! C/4 ? 1E+50! and % ? 10 to solve for '",4 ? =1!40E.+F N =1!40E. Lsing a financial calculator! input the followingB C/ 0 ? -++500! C/1 ? :+50! 'j ? 4! C/8 ? 11+50! and % ? 10 to solve for '",8 ? =E+:.E4 N =E+E. Lsing a financial calculator! input the followingB C/ 0 ? -++500! C/1 ? :+50! 'j ? 5! and % ? 10 to solve for '",5 ? =1!1F+.8+ N =1!1F+. The firm should operate the truc for 4 years! '",4 ? =1!40E. b. 'o. 2alvage possibilities could only raise '", and %--. The value of the firm is maximized by terminating the project after 7ear 4.

Answers and Solutions: 10 " (-

S *&T' N T

S$REA!S#EET $R B*E+

10-1@ The detailed solution for the problem is available both on the instructor0s resource C.-K) #in the file Solution for FM11 Ch 10 P18 Build a Model.xls $ and on the instructor0s side of the web site! 2righa34swcollege4co3.

Answers and Solutions: 10 " (.

+'N' CASE

5ou have 6ust graduated fro3 the +BA progra3 of a large universit78 and one of 7our favorite courses was 9Toda7:s Entrepreneurs4; 'n fact8 7ou en6o7ed it so 3uch 7ou have decided 7ou want to 92e 7our own 2oss4; While 7ou were in the 3aster:s progra38 7our grandfather died and left 7ou <)008000 to do with as 7ou please4 5ou are not an inventor and 7ou do not have a trade s=ill that 7ou can 3ar=et> however8 7ou have decided that 7ou would li=e to purchase at least one esta2lished franchise in the fast foods area8 3a72e two ?if profita2le@4 The pro2le3 is that 7ou have never 2een one to sta7 with an7 pro6ect for too long8 so 7ou figure that 7our ti3e fra3e is three 7ears4 After three 7ears 7ou will sell off 7our invest3ent and go on to so3ething else4 5ou have narrowed 7our selection down to two choices> ?1@ Franchise *A *isa:s Soups8 Salads8 B Stuff and ?(@ Franchise SA Sa3:s Wonderful Fried Chic=en4 The net cash flows shown 2elow include the price 7ou would receive for selling the franchise in 7ear ) and the forecast of how each franchise will do over the three"7ear period4 Franchise *:s cash flows will start off slowl7 2ut will increase rather Cuic=l7 as people 2eco3e 3ore health conscious8 while Franchise S:s cash flows will start off high 2ut will trail off as other chic=en co3petitors enter the 3ar=etplace and as people 2eco3e 3ore health conscious and avoid fried foods4 Franchise * serves 2rea=fast and lunch8 while franchise S serves onl7 dinner8 so it is possi2le for 7ou to invest in 2oth franchises4 5ou see these franchises as perfect co3ple3ents to one anotherA 7ou could attract 2oth the lunch and dinner crowds and the health conscious and not so health conscious crowds with the franchises directl7 co3peting against one another4 #ere are the pro6ectsD net cash flows ?in thousands of dollars@A 5ear EEpected Net Cash Flow Franchise * Franchise S 0 ?<100@ ?<100@ 1 10 /0 ( .0 -0 ) 00 (0

!epreciation8 salvage values8 net wor=ing capital reCuire3ents8 and taE effects are all included in these cash flows4 5ou also have 3ade su26ective ris= assess3ents of each franchise8 and concluded that 2oth franchises have ris= characteristics that reCuire a return of 10 percent4 5ou 3ust now deter3ine whether one or 2oth of the pro6ects should 2e accepted4 Mini Case: 10 " (/

a4

What is capital 2udgetingF

AnswerA Capital budgeting is the process of analyzing additions to fixed assets. Capital budgeting is important because! more than anything else! fixed asset investment decisions chart a company&s course for the future. Conceptually! the capital budgeting process is identical to the decision process used by individuals ma ing investment decisions. These steps are involvedB 1. 3stimate the cash flows--interest and maturity value or dividends in the case of bonds and stoc s! operating cash flows in the case of capital projects. +. 1ssess the ris iness of the cash flows. 4. .etermine the appropriate discount rate! based on the ris iness of the cash flows and the general level of interest rates. This is called the project cost of capital in capital budgeting. 8. 3valuate the cash flows. 24 What is the difference 2etween independent and 3utuall7 eEclusive pro6ectsF

AnswerA "rojects are independent if the cash flows of one are not affected by the acceptance of the other. Conversely! two projects are mutually exclusive if acceptance of one impacts adversely the cash flows of the other6 that is! at most one of two or more such projects may be accepted. "ut another way! when projects are mutually exclusive it means that they do the same job. /or example! a for lift truc versus a conveyor system to move materials! or a bridge versus a ferry boat. "rojects with normal cash flows have outflows! or costs! in the first year #or years$ followed by a series of inflows. "rojects with nonnormal cash flows have one or more outflows after the inflow stream has begun. Rere are some examplesB %nflow #G$ Kr Kutflow #-$ %n 7ear 'ormal
0 G 1 G G G G + 4 G G G G - G G G G 8 G G G 5 G G G -

'onnormal

G G - G - -

Mini Case: 10 " (0

c4

14 What is the pa72ac= periodF Find the pa72ac=s for franchises * and S4

AnswerA The paybac period is the expected number of years re(uired to recover a project&s cost. *e calculate the paybac by developing the cumulative cash flows as shown below for project l #in thousands of dollars$B 7ear 0 1 + 4
| -100

3xpected 'C/ 1nnual Cumulative #=100$ #=100$ 10 #F0$ :0 #40$ @0 50

| 10 -F0

"aybac is between t ? + and t ?4

| :0 -40

| @0 G50

/ranchise P&s =100 investment has not been recovered at the end of year +! but it has been more than recovered by the end of year 4. Thus! the recovery period is between + and 4 years. %f we assume that the cash flows occur evenly over the year! then the investment is recovered =40>=@0 ? 0.4E5 N 0.8 into year 4. Therefore! paybac P ? +.8 years. 2imilarly! paybac 2 ? 1.: years. c4 (4 What is the rationale for the pa72ac= 3ethodF According to the pa72ac= criterion8 which franchise or franchises should 2e accepted if the fir3Ds 3aEi3u3 accepta2le pa72ac= is ( 7ears8 and if franchises * and S are independentF 'f the7 are 3utuall7 eEclusiveF

AnswerA "aybac represents a type of <brea even< analysisB the paybac period tells us when the project will brea even in a cash flow sense. *ith a re(uired paybac of + years! franchise 2 is acceptable! but franchise P is not. *hether the two projects are independent or mutually exclusive ma es no difference in this case.

Mini Case: 10 " (1

c4

)4 What is the difference 2etween the regular and discounted pa72ac= periodsF

AnswerA .iscounted paybac is similar to paybac except that discounted rather than raw cash flows are used. 2etup for franchise P&s discounted paybac ! assuming a 10D cost of capitalB 7ear 0 1 + 4 .iscounted "aybac
P

3xpected 'et Cash /lows -aw .iscounted #=100$ #=100.00$ 10 F.0F :0 8F.5F @0 :0.11

Cumulative #=100.00$ #F0.F1$ #81.4+$ 1@.EF

? + G #=81.4+>=:0.11$ ? +.:F ? +.E years.

,ersus +.8 years for the regular paybac . c4 ,4 What is the 3ain disadvantage of discounted pa72ac=F 's the pa72ac= 3ethod of an7 real usefulness in capital 2udgeting decisionsF

AnswerA -egular paybac has two critical deficienciesB #1$ it ignores the time value of money! and #+$ it ignores the cash flows that occur after the paybac period. .iscounted paybac does consider the time value of money! but it still fails to consider cash flows after the paybac period6 hence it has a basic flaw. %n spite of its deficiency! many firms today still calculate the discounted paybac and give some weight to it when ma ing capital budgeting decisions. Rowever! paybac is not generally used as the primary decision tool. -ather! it is used as a rough measure of a project&s li(uidity and ris iness.

Mini Case: 10 " )0

d4

14 !efine the ter3 net present value (NPV). What is each franchiseDs N$GF

AnswerA The net present value #'",$ is simply the sum of the present values of a project&s cash flowsB '", ? /ranchise P&2 '", is =1@.EFB
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t =0

#1 + rt$ t

C/

0 10D

4
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#100.00$ 10 F.0F 8F.5F :0.11 1@.EF ? '",P

:0

@0

'",s are easy to determine using a calculator with an '", function. 3nter the cash flows se(uentially! with outflows entered as negatives6 enter the cost of capital6 and then press the '", button to obtain the project&s '",! =1@.E@ #note the penny rounding difference$. The '", of franchise 2 is '",2 ? =1F.F@.

Mini Case: 10 " )1

d4

(4 What is the rationale 2ehind the N$G 3ethodF According to N$G8 which franchise or franchises should 2e accepted if the7 are independentF +utuall7 eEclusiveF

AnswerA The rationale behind the '", method is straightforwardB if a project has '", ? =0! then the project generates exactly enough cash flows #1$ to recover the cost of the investment and #+$ to enable investors to earn their re(uired rates of return #the opportunity cost of capital$. %f '", ? =0! then in a financial #but not an accounting$ sense! the project brea s even. %f the '", is positive! then more than enough cash flow is generated! and conversely if '", is negative. Consider franchise P&s cash inflows! which total =150. They are sufficient #1$ to return the =100 initial investment! #+$ to provide investors with their 10 percent aggregate opportunity cost of capital! and #4$ to still have =1@.EF left over on a present value basis. This =1@.EF excess ", belongs to the shareholders--the debtholders& claims are fixed! so the shareholders& wealth will be increased by =1@.EF if franchise P is accepted. 2imilarly! 1xis&s shareholders gain =1F.F@ in value if franchise 2 is accepted. %f franchises P and 2 are independent! then both should be accepted! because they both add to shareholders& wealth! hence to the stoc price. %f the franchises are mutually exclusive! then franchise 2 should be chosen over P! because s adds more to the value of the firm. d4 )4 Would the N$Gs change if the cost of capital changedF

AnswerA The '", of a project is dependent on the cost of capital used. Thus! if the cost of capital changed! the '", of each project would change. '", declines as r increases! and '", rises as r falls.

Mini Case: 10 " )(

e4

14 !efine the ter3 nternal !ate "f !eturn ( !!)4 What is each franchiseDs 'RRF

AnswerA The internal rate of return #%--$ is that discount rate which forces the '", of a project to e(ual zeroB 0 %-|

1
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+
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4
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C/0 C/1 C/+ ",C/1 ",C/+ ",C/4 0 ? 2L) K/ ",s ? '",. 3xpressed as an e(uation! we haveB %--B
t #1 + %-$t n

C/4

C/

t =0

? =0 ? '",.

'ote that the %-- e(uation is the same as the '", e(uation! except that to find the %-- the e(uation is solved for the particular discount rate! %--! which forces the project&s '", to e(ual zero #the %--$ rather than using the cost of capital #r$ in the denominator and finding '",. Thus! the two approaches differ in only one respectB in the '", method! a discount rate is specified #the project&s cost of capital$ and the e(uation is solved for '",! while in the %-- method! the '", is specified to e(ual zero and the discount rate #%--$ which forces this e(uality is found. /ranchise P&s %-- is 1@.1 percentB
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0 1@.1D

1
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+
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4
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-100.00 10 :0 @0 @.8E 84.0+ 8@.5E = 0.0: N =0 if %--P ? 1@.1D is used as the discount rate. therefore! %--P N 1@.1D.

1 financial calculator is extremely helpful when calculating %--s. The cash flows are entered se(uentially! and then the %-- button is pressed. /or franchise 2! %-- 2 N +4.:D. 'ote that with many calculators! you can enter the cash flows into the cash flow register! also enter r ? i! and then calculate both '", and %-- by pressing the appropriate buttons.

Mini Case: 10 " ))

e4

(4 #ow is the 'RR on a pro6ect related to the 5T+ on a 2ondF

AnswerA The %-- is to a capital project what the 7T) is to a bond. %t is the expected rate of return on the project! just as the 7T) is the promised rate of return on a bond. e4 )4 What is the logic 2ehind the 'RR 3ethodF According to 'RR8 which franchises should 2e accepted if the7 are independentF +utuall7 eEclusiveF

AnswerA %-- measures a project&s profitability in the rate of return senseB if a project&s %-e(uals its cost of capital! then its cash flows are just sufficient to provide investors with their re(uired rates of return. 1n %-- greater than r implies an economic profit! which accrues to the firm&s shareholders! while an %-- less than r indicates an economic loss! or a project that will not earn enough to cover its cost of capital. "rojects& %--s are compared to their costs of capital! or hurdle rates. 2ince franchises P and 2 both have a hurdle rate of 10 percent! and since both have %--s greater than that hurdle rate! both should be accepted if they are independent. Rowever! if they are mutually exclusive! franchise 2 would be selected! because it has the higher %--. e4 ,4 Would the franchisesD 'RRs change if the cost of capital changedF

AnswerA %--s are independent of the cost of capital. Therefore! neither %-- 2 nor %--P would change if r changed. Rowever! the acceptability of the franchises could change--P would be rejected if r were above 1@.1D! and 2 would also be rejected if r were above +4.:D. f4 14 !raw N$G profiles for franchises * and S4 At what discount rate do the profiles crossF

AnswerA the '", profiles are plotted in the figure below. 'ote the following pointsB 1. The y-intercept is the project&s '", when r ? 0D. This is =50 for P and =80 for 2. +. The x-intercept is the project&s %--. This is 1@.1 percent for l and +4.: percent for 2.

Mini Case: 10 " ),

4. '", profiles are curves rather than straight lines. To see this! note that these profiles approach cost ? -=100 as r approaches infinity. 8. /rom the figure below! it appears that the crossover point is between @ and F percent. The precise value is approximately @.E percent. Kne can calculate the crossover rate by #1$ going bac to the data on the problem! finding the cash flow differences for each year! #+$ entering those differences into the cash flow register! and #4$ pressing the %-- button to get the crossover rate! @.:@D N @.ED.

60 50 40 30 20 10 0 0 -10 5 10 15 20 23.6

r '",P '",2 0D =50 =80 5 44 +F 10 1F +0 15 E 1+ +0 #8$ 5

Mini Case: 10 " )-

f4

(4 *oo= at 7our N$G profile graph without referring to the actual N$Gs and 'RRs4 Which franchise or franchises should 2e accepted if the7 are independentF +utuall7 eEclusiveF EEplain4 Are 7our answers correct at an7 cost of capital less than ()4. percentF

AnswerA The '", profiles show that the %-- and '", criteria lead to the same accept>reject decision for any independent project. Consider franchise P. %t intersects the x-axis at its %--! 1@.1 percent. 1ccording to the %-- rule! P is acceptable if r is less than 1@.1 percent. 1lso! at any r less than 1@.1 percent! P&s '", profile will be above the x axis! so its '", will be greater than =0. Thus! for any independent project! '", and %-- lead to the same accept>reject decision. 'ow assume that P and 2 are mutually exclusive. %n this case! a conflict might arise. /irst! note that %--2 ? +4.:D O 1@.1D ? therefore! regardless of the size of r! project 2 would be ran ed higher by the %-- criterion. Rowever! the '", profiles show that '",P O '",2 if r is less than @.E percent. Therefore! for any r below the @.ED crossover rate! say r ? E percent! the '", rule says choose P! but the %-- rule says choose 2. Thus! if r is less than the crossover rate! a ran ing conflict occurs. g4 14 What is the underl7ing cause of ran=ing conflicts 2etween N$G and 'RRF

AnswerA /or normal projects& '", profiles to cross! one project must have both a higher vertical axis intercept and a steeper slope than the other. 1 project&s vertical axis intercept typically depends on #1$ the size of the project and #+$ the size and timing pattern of the cash flows--large projects! and ones with large distant cash flows! would generally be expected to have relatively high vertical axis intercepts. The slope of the '", profile depends entirely on the timing pattern of the cash flows-long-term projects have steeper '", profiles than short-term ones. Thus! we conclude that '", profiles can cross in two situationsB #1$ when mutually exclusive projects differ in scale #or size$ and #+$ when the projects& cash flows differ in terms of the timing pattern of their cash flows #as for franchises P and 2$. g4 (4 What is the Hreinvest3ent rate assu3ption;8 and how does it affect the N$G versus 'RR conflictF

AnswerA The underlying cause of ran ing conflicts is the reinvestment rate assumption. 1ll .C/ methods implicitly assume that cash flows can be reinvested at some rate! regardless of what is actually done with the cash flows. .iscounting is the reverse of compounding. 2ince compounding assumes reinvestment! so does discounting. '", and %-- are both found by discounting! so they both implicitly assume some discount rate. %nherent in the '", calculation is the assumption that cash flows can be reinvested at the project&s cost of capital! while the %-- calculation assumes reinvestment at the %-- rate. Mini Case: 10 " ).

g4

)4 Which 3ethod is the 2estF Wh7F

AnswerA *hether '", or %-- gives better ran ings depends on which has the better reinvestment rate assumption. 'ormally! the '",&s assumption is better. The reason is as followsB a project&s cash inflows are generally used as substitutes for outside capital! that is! projects& cash flows replace outside capital and! hence! save the firm the cost of outside capital. Therefore! in an opportunity cost sense! a project&s cash flows are reinvested at the cost of capital. To see this graphically! thin of the following situationB assume the firm&s cost of capital is a constant 10D within the relevant range of financing considered! and it has projects available as shown in the graph belowB
Perce%t
"5 *hat projects will be accepted! by either '", or %--Q "rojects 1! M! C! and .. %f the same situation exists year after year! at what rate of return will cash flows from earlier years& investments be reinvestedQ Capital budgeting decisions are made +((B ) "0% 0 in this " se(uenceB #1$ the company would say! <we can ta e on 1! M! C! and . and finance them with 10D money! so let&s do it.< #+$ then! it would get cash flows from earlier years& projects. *hat would it do with those cash flowsQ %t would use them in +((C ) 15% lieu of 1raising money that costs 10D! so it would save 10D. Therefore! 10D is the 5 opportunity cost of the cash flows. %n effect! cash flows are reinvested at the 10D +((& ) 1"% cost of capital. $CC 'ote! 1 0 however! that '", and %-- always give the same accept>reject decisions for independent projects! so %-- can be used just as '", when independent + (well ( 1 )as 8% projects are being evaluated. The '", versus %-- conflict arises only if mutually +((2 ) 5% exclusive 5 projects are involved.

+((A ) "5%

&ollars (aise0 a%0 +%'este0

Mini Case: 10 " )/

h4

14 !efine the ter3 Modified !! (M !!). Find the +'RRs for franchises * and S4

AnswerA )%-- is that discount rate which e(uates the present value of the terminal value of the inflows! compounded at the cost of capital! to the present value of the costs. Rere is the setup for calculating franchise P&s modified %--B 0r ? 10D
|

1
|

+
|

4
|

", Kf Costs ? #100.00$

", Kf T, ? 100.00 ? =100 ?

=15@.10 #1 + )%-- $ 4 T, #1 + )%-- $ n

@0.00 ::.00 1+.10 T, K/ %'/PK*2 ? 15@.10 )%-- ? Q .

n

10

:0

", costs ?

t =0 #1 + r $

CK/t
t

t =1

C%/t #1 + r $ n t
#1 + )%-- $
n

1fter you calculate the T,! enter n ? 4! ", ? -100! pmt ? 0! fv ? 15@.1! and then press i to get the answer! )%--P ? 1:.5D. *e could calculate )%--2 similarlyB ? 1:.FD. Thus! franchise 2 is ran ed higher than P. This result is consistent with the '", decision.

Mini Case: 10 " )0

h4

(4 What are the +'RRDs advantages and disadvantages vis"a"vis the regular 'RRF What are the +'RRDs advantages and disadvantages vis"a"vis the N$GF

AnswerA )%-- is a better rate of return measure than %-- for two reasonsB #1$ it correctly assumes reinvestment at the project&s cost of capital rather than at its %--. #+$ )%-avoids the problem of multiple %--s--there can be only one )%-- for a given project. )%-- does not always lead to the same decision as '", when mutually exclusive projects are being considered. %n particular! small projects often have a higher )%--! but a lower '",! than larger projects. Thus! )%-- is not a perfect substitute for '",! and '", remains the single best decision rule. Rowever! )%-is superior to the regular %--! and if a rate of return measure is needed! )%-- should be used. Musiness executives agree. 1s noted in the text! business executives prefer to compare projects& rates of return to comparing their '",s. This is an empirical fact. 1s a result! financial managers are substituting )%-- for %-- in their discussions with other corporate executives. This fact was brought out in the Kctober 1F@F /)1 meetings! where executives from .u "ont! Rershey! and 1meritech! among others! all reported a switch from %-- to )%--.

Mini Case: 10 " )1

i4

As a separate pro6ect ?pro6ect $@8 7ou are considering sponsoring a pavilion at the upco3ing worldDs fair4 The pavilion would cost <00080008 and it is eEpected to result in <- 3illion of incre3ental cash inflows during its 1 7ear of operation4 #owever8 it would then ta=e another 7ear8 and <- 3illion of costs8 to de3olish the site and return it to its original condition4 Thus8 pro6ect $Ds eEpected net cash flows loo= li=e this ?in 3illions of dollars@A 5ear 0 1 ( Net Cash Flows ?<040@ -40 ?-40@

The pro6ect is esti3ated to 2e of average ris=8 so its cost of capital is 10 percent4 i4 14 What are nor3al and nonnor3al cash flowsF

AnswerA 'ormal cash flows begin with a negative cash flow #or a series of negative cash flows$! switch to positive cash flows! and then remain positive. They have only one change in sign. #'oteB normal cash flows can also start with positive cash flows! switch to negative cash flows! and then remain negative.$ 'onnormal cash flows have more than one sign change. /or example! they may start with negative cash flows! switch to positive! and then switch bac to negative.

Mini Case: 10 " ,0

i4

(4 What is pro6ect $:s N$GF What is its 'RRF 'ts +'RRF

AnswerA Rere is the time line for the cash flows! and the '",B 0
|

10D

1
|

+
|

-@00!000

5!000!000 '"," ? -=4@:!EE:.@:.

-5!000!000

*e can find the '", by entering the cash flows into the cash flow register! entering i ? 10! and then pressing the '", button. Rowever! calculating the %-- presents a problem. *ith the cash flows in the register! press the %-- button. 1n hp-10b financial calculator will give the message <error-soln.< This means that project " has multiple %--s. 1n R"-1EM will as for a guess. %f you guess 10D! the calculator will produce %-- ? +5D. %f you guess a high number! such as +00D! it will produce the second %--! 800D1. The )%-- of project " ? 5.:D! and is found by computing the discount rate that e(uates the terminal value #=5.5 million$ to the present value of cost #=8.F4 million$. i4 )4 !raw pro6ect $Ds N$G profile4 !oes pro6ect $ have nor3al or non"nor3al cash flowsF Should this pro6ect 2e acceptedF

AnswerA 7ou could put the cash flows in your calculator and then enter a series of i values! get an '", for each! and then plot the points to construct the '", profile. *e used a spreadsheet program to automate the process and then to draw the profile. 'ote that the profile crosses the x-axis twice! at +5D and at 800D! signifying two %--s. *hich %-- is correctQ %n one sense! they both are--both cause the project&s '", to e(ual zero. Rowever! in another sense! both are wrong--neither has any economic or financial significance. "roject " has nonnormal cash flows6 that is! it has more than one change of signs in the cash flows. *ithout this nonnormal cash flow pattern! we would not have the multiple %--s. 2ince project "&s '", is negative! the project should be rejected! even though both %--s #+5D and 800D$ are greater than the project&s 10 percent cost of capital. The )%-of 5.:D also supports the decision that the project should be rejected. '",
500

4E5

+50

1 Poo ing at the figure below! if you guess an %-- to the left of the pea '", rate! the lower %-- will

appear. %f you guess1+5 %-- O pea '", rate! the higher %-- will appear.
Cost of Capital! r #D$ -1+5 -+50 -4E5 100 +00 400 800 500 :00

Mini Case: 10 " ,1

64

'n an unrelated anal7sis8 7ou have the opportunit7 to choose 2etween the following two 3utuall7 eEclusive pro6ectsA EEpected Net Cash Flows 5ear $ro6ect S $ro6ect * 0 ?<1008000@ ?<1008000@ 1 .08000 ))8-00 ( .08000 ))8-00 ) "" ))8-00 , "" ))8-00 The pro6ects provide a necessar7 service8 so whichever one is selected is eEpected to 2e repeated into the foreseea2le future4 Both pro6ects have a 10 percent cost of capital4

64

14 What is each pro6ectDs initial npv without replicationF

AnswerA The '",s! found with a financial calculator! are calculated as followsB %nput the followingB C/0 ? -100000! C/1 ? :0000! 'W ? +! 1'. % ? 10 to solve for '",2 ? =8!14+.+4 N =8!14+. %nput the followingB C/0 ? -100000! C/1 ? 44500! 'W ? 8! 1'. % ? 10 to solve for '",P ? =:!1F0.8F N =:!1F0. Rowever! if we ma e our decision based on the raw '",s! we would be biasing the decision against the shorter project. 2ince the projects are expected to be replicated! if we initially choose project 2! it would be repeated after + years. Rowever! the raw '",s do not reflect the replication cash flows.

Mini Case: 10 " ,(

64

(4 Now appl7 the replace3ent chain approach to deter3ine the pro6ects: eEtended N$Gs4 Which pro6ect should 2e chosenF

AnswerA The simple replacement chain approach assumes that the projects will be replicated out to a common life. 2ince project 2 has a +-year life and P has a 8-year life! the shortest common life is 8 years. "roject P&s common life '", is its raw '",B Common Pife '",P ? =:!1F0. Rowever! project 2 would be replicated in year +! and if we assume that the replicated project&s cash flows are identical to the first set of cash flows! then the replicated '", is also =8!14+! but it <comes in< in year +. *e can put project 2&s cash flow situation on a time lineB 0
|

10D

1
|

+
|

4
|

8
|

8!14+ 4!815 E!58E

8!41+

Rere we see that 2&s common life '", is '",2 ? =E!58E. Thus! when compared over a 8-year common life! project s has the higher '",! hence it should be chosen. "roject s would have the higher '", over any common life.

Mini Case: 10 " ,)

64

)4 Now assu3e that the cost to replicate pro6ect S in ( 7ears will increase to <10-8000 2ecause of inflationar7 pressures4 #ow should the anal7sis 2e handled now8 and which pro6ect should 2e chosenF

AnswerA %f the cost of project 2 is expected to increase! the replication project is not identical to the original! and the 311 approach cannot be used. %n this situation! we would put the cash flows on a time line as followsB 0 r ? 10D
|

1
|

+
|

4
|

8
|

-100!000

:0!000

:0!000 -105!000 - 85!000

:0!000

:0!000

Common Pife '",2 ? =4!815. *ith this change! the common life '", of project s is less than that for project P! and hence project P should be chosen. =4 5ou are also considering another pro6ect which has a ph7sical life of ) 7ears> that is8 the 3achiner7 will 2e totall7 worn out after ) 7ears4 #owever8 if the pro6ect were ter3inated prior to the end of ) 7ears8 the 3achiner7 would have a positive salvage value4 #ere are the pro6ect:s esti3ated cash flowsA 'nitial 'nvest3ent And perating Cash Flows ?<-8000@ (8100 (8000 18/-0 End" f"5ear Net Salvage GalueI <-8000 )8100 (8000 0

5ear 0 1 ( )

&sing the 10 percent cost of capital8 what is the pro6ect:s N$G if it is operated for the full ) 7earsF Would the N$G change if the co3pan7 planned to ter3inate the pro6ect at the end of 7ear (F At the end of 7ear 1F What is the pro6ect:s opti3al ?econo3ic@ lifeF

Mini Case: 10 " ,,

AnswerA Rere are the time lines for the 4 alternative livesB 'o terminationB 0 10D
|

1
|

+
|

4
|

-5!000

+!100

+!000

1!E50 0 1!E50

'", ? -=1+4. Terminate after + yearsB 0 10D

|

1
|

+
|

-5!000

+!100

+!000 +!000 8!000

'", ? =+15. Terminate after 1 yearB 0 10D

|

1
|

-5!000

+!100 4!100 5!+00

'", ? -=+E4. *e see #1$ that the project is acceptable only if operated for + years! and #+$ that a project&s engineering life does not always e(ual its economic life.

Mini Case: 10 " ,-

l4

After eEa3ining all the potential pro6ects8 7ou discover that there are 3an7 3ore pro6ects this 7ear with positive N$Gs than in a nor3al 7ear4 What two pro2le3s 3ight this eEtra large capital 2udget causeF 7ou only have a limited amount of capital to commit to projects. %f you have to raise external capital to fund some of these other positive '", projects! then you may be faced with an increasing cost of capital. This is called an increasing marginal cost of capital schedule! and it also happens to companies when they exhaust their internal sources of funds and have to go to external capital mar ets for their finding. This increased cost of capital may cause you to reject projects that you might otherwise accept because with your increased cost of capital! some projects may be negative '", when they would otherwise be positive '", in a normal year. 1nother effect of this large capital budget is that you may choose to ration capitalX i.e. not fund all of the projects. This is called capital rationing! and companies and investors do this when for whatever reason they put a cap on the funds they are willing to invest in new projects.

Mini Case: 10 " ,.