Peirson12e SM CH05

Chapter 5
Project evaluation: principles and

methods
Solutions to questions
1.
Broadly speaking, the capital-expenditure process involves the following four steps:
(a) The first step is the generation of investment proposals. Investment proposals can
originate from any level in a company, from employees on the shop floor to top
management. Many ideas for investment proposals are generated at lower levels in
the organisation, where any waste or inefficiency in its operations are likely to be
readily apparent. For example, employees on the shop floor may be aware of
equipment that needs to be replaced, or they may have ideas for improving the
entitys operations. In contrast, top management is more likely to have ideas for
plant expansion, new product development, diversification, corporate takeovers and
other large capital expenditures. The generation of good ideas for capital expenditure
will be facilitated if there is a systematic means of searching for them. In some
companies, for example, the search for investment opportunities is assigned to a
corporate planning department.
(b) The second step in the process is the evaluation and selection of investment
proposals. In order to evaluate proposals, it is necessary to assemble the data
required to evaluate them. Many companies use standard evaluation forms and
procedures so that all proposals are assessed on a uniform basis. The data for a
proposal should include:
(i)
a brief description of the proposal;
(ii) a statement indicating why it is necessary;
(iii) an estimate of the amount and timing of the cash outlays;
(iv) an estimate of the amount and timing of the cash inflows;
(v) an estimate of when the proposal will come into operation; and
(vi) an estimate of its economic life.
Using these data, an economic evaluation of proposals is made and proposals
selected on the basis of this evaluation.
(c) The third step in the process is the approval and control of capital expenditures.
After selection of the investment projects, a capital-expenditure budget, which
details the estimated capital expenditure on new and continuing projects for each of
the next few years, should be prepared. The main reason for developing a capitalexpenditure budget is to ensure that expenditures are kept within the authorised
Solutions manual to accompany Business Finance 11e by Peirson, Brown, Easton, Howard and Pinder
McGraw-Hill Education (Australia) 2015
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CHAPTER 5
limits, so that the timing of the expenditures, particularly for major items, is
consistent with other demands on the companys resources and with the companys
overall financial plan.
After an investment project has been approved and the spending of a sum of money
authorised, the company needs appropriate administrative procedures to implement
it. As a first step, a project manager is appointed to be responsible for the
implementation of each project. Implementation will include the adoption of a
realistic timetable for the projects completion, and procedures for controlling costs.
The time taken to complete a project is important, as any delay in its completion is
likely to result in foregoing cash inflows. Even a short delay in a projects
implementation may cause it to become unprofitable. To assist in controlling costs, a
separate account may be established for each project. This account will be charged
with the outlays as the invoices are received. Control over expenditure will be
facilitated by the submission of progress reports to management. These reports
compare the amount spent on the project, and its expected date of completion, with
the forecasts. If the expenditures are significantly above budget, or the project has
fallen well behind schedule, the project should be reassessed, as it may no longer be
profitable to proceed with it.
(d) After a project has been in operation for a reasonable period, it is important to
consider whether it is performing to expectations. Such an assessment is referred to
as a post-completion audit. It is an essential part of the capital-expenditure process.
The audit report should highlight any cash flows that have deviated significantly
from budget, and, where possible, provide explanations for those deviations.
2.
The required rate of return for a project reflects the rate of return that could be generated
by investing in the next best alternative investment. This discount rate reflects the return
required by the firm as compensation for having funds tied up in the project. The
compensation demanded increases as the uncertainty, or risk, associated with the
projects expected cash-flow increases. The firm will also require more from a project as
expected inflation increases as additional compensation for the loss in the purchasing
power of the funds invested in the project. Even in the absence of either risk or inflation,
the firm will still demand compensation from the project, as it has incurred an
opportunity cost in investing in this project as opposed to investing in an incomegenerating risk-free asset such as a government-issued debt security.
3.
The net present value of a project is found by discounting the expected future net cash
flows at the required rate of return and deducting, from the resulting present value, the
projects initial cash outlay. If the project has a positive net present value, it is
acceptable. The internal rate of return of a project is the rate of return that results in a
zero net present value. If projects are independent, the decision involves either accepting
or rejecting them. In this case, and assuming that there is only one internal rate of return,
the two methods lead to the same accept/reject decisions. If the projects are mutually
exclusive, it is possible that the two methods will rank projects in a different order. The
reasons for this are outlined in Section 5.4.3.
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CHAPTER 5
4.
Two projects are said to be independent if the acceptance of one project does not affect
the acceptance of the other project. Two conditions are necessary for projects to be
independent. First, it must be technically feasible to undertake one project irrespective of
the decision made concerning the other project. Second, the net cash flows from each
project must be unaffected by the acceptance or rejection of the other project. Two
projects are said to be mutually exclusive if the net cash flows from a project will
completely disappear if the other project is accepted, or it is technically impossible to
undertake the project if the other project is accepted.
5.
There is evidence that financial managers use more than one method to evaluate projects
in order to ensure that projects are acceptable according to a number of criteria set down
by management. For example, because management places considerable emphasis on a
companys return on investment, it has been suggested that a projects accounting rate of
return should be calculated, as well as its net present value. As a result, management is
able to take into account the impact of accepting a project on the companys return on
investment.
6.
This statement is incorrect. Before a project can be regarded as acceptable, the internal
rate of return must be compared with the required rate of return. If r > k, the project is
acceptable. If r < k, it is not acceptable.
7.
The use of the accounting rate of return has two fundamental problems:
(a) It is based on accounting earnings rather than cash flowstherefore, the depreciation
method employed will have a substantial bearing on the measurement of earnings and on
the accounting rate of return.
(b) It ignores the timing of the earnings streamthat is, equal weight is given to the
earnings in each year of the projects life. The accounting rate of return therefore fails to
take account of the time value of money.
The use of the payback method also has some problems:
(a) Calculation of the payback period takes into account only the net cash flows up to the
point where they equal the investment outlay. The payback method therefore
discriminates against projects with long gestation periods and large cash flows late in
their lives.
(b) The payback period is not a measure of a projects profitability. Mere recovery of the
outlay on a project yields no profit at all. If there is a profit on the project, it must be due
to additional cash flows after the investment outlay has been recovered.
The major weakness of the payback method is its failure to take account of the
magnitude and timing of all of a projects cash inflows and outflows.
8.
The statement is true, because even if the projects are independent, it is possible that a
projects pattern of cash flows may give rise to multiple internal rates of return or to no
internal rate of return.
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9.
CHAPTER 5
For independent investments, both the IRR and NPV methods of project evaluation lead
to the same accept/reject decisions, except for those investments where the cash flow
patterns result in either multiple IRRs or no IRR. In other words, if a project has an IRR
greater than the required rate of return, then the project will also have a positive NPV
when its cash flows are discounted at the required rate of returnthat is, NPV > 0 when r
> k, NPV < 0 when r < k, and NPV = 0 when r = k. This is always true provided that the
projects net cash flows consist of one or more periods of cash outlay, followed only by
positive net cash flows. This can be illustrated by reference to Figure 5.2.
10. If an independent project has an internal rate of return, the project will also have a
positive NPV when its cash flows are discounted at the required rate of return. This is
always true, provided that the projects cash flows consist of one or more periods of cash
outlay followed only by positive net cash flows. Such a project is referred to as a
conventional project. The NPV profile of such a project is shown in Figure 5.2. It shows
that the higher the discount rate, the lower the NPV, and k = r at the point where the
NPV profile intercepts the horizontal axisthat is, the NPV = 0.
11. This statement is true, as the payback period method only accounts for net cash flows up
to the point where they equal the initial investment outlay, and, hence, any value created
by cash flows occurring subsequent to this point are ignored..
12. The accounting rate of return method is often used in addition to the discounted cash
flow methods because financial analysts generally use accounting information to assess
performance year by year. To overcome the problems with measuring the accounting rate
of return identified in Section 5.5.1, the economic value added (EVA) approach to
measuring performance was introduced by consulting firms in the United Statesthat is,
EVA is used to overcome the problems with measuring return on investment (ROI).
13. This observation is consistent with managers recognising that by choosing to proceed
with a project, they are giving up something of value (e.g. the flexibility to wait and
allow uncertainty to resolve itself), and that this value is not incorporated into standard
NPV analysis. Hence, observing that managers require that a project delivers more than
simply the risk-adjusted rate of return may be interpreted as the managers implicitly
incorporating compensation for the value of any real options lost by proceeding with a
project.
14. According to survey evidence across multiple markets across an extended period of time,
and as illustrated in Figure 5.1, real options analysis is far less popular with financial
managers than discounted cash flow approaches to project evaluation. Later empirical
work has tried to work out why this is the case and it seems that the reason is twofold.
Firstly, estimating the value of a real option can rely upon modelling that looks, relative
to standard project evaluation, quite complex and it seems that many managers believe
that they dont have the right skillset at their disposal to perform the calculations
correctly. Perhaps more importantly though, there is some evidence that managers
believe that senior members of the organisationthat is, boards of directorsdo not
support the application of the technique. One possible reason for this lack of support is
that real options analysis often makes projects look more attractive than suggested by
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CHAPTER 5
standard discounted cash flow approaches, particularly where the initial investment
provides the firm with valuable follow-up growth options. A board of directors might be
sceptical where they believe that real options analysis is being inappropriately used by
management to allow them to invest in projects that do not meet the firm-wide required
rate of return.
Solutions to problems
1.
Problem 1
$150,000.00
$100,000.00
NPV(A)
NPV
$50,000.00
NPV(B)
$0.00
NPV(C)
0%
3%
6%
9%
12%
15%
18%
-$50,000.00
-$100,000.00
Discount rate
(a) (i)
(ii)
NPVA = $33 699, NPVB = $22 244, NPVC = $40 692; therefore, prefer project
C, then A and then B.
NPVA = $0, NPVB = $0, NPVC = $0; therefore, indifferent between each of the
projects.
(iii) NPVA = $33 522, NPVB = $23 140, NPVC = $39 859; therefore, all of the
projects are unacceptable.
(b) The internal rates of return for all of the projects are equal to 10%, and hence we
cannot differentiate between them on the basis of this project evaluation technique.
For example, if the required return for all of the projects was 6%, and the projects
were mutually exclusive, then we would be unable to decide between the projects
without calculating the each projects NPV.
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2.
CHAPTER 5
Net present value

Proposal A:
$8 000 $48 000
1.1
(1.1) 2
= $40 000 + $7273 + $39 670
= $6943
= $40 000
NPV
Proposal B:
$42 000
1.1
= $40 000 + $38 182
= $1818
= $40 000 +
NPV
Proposal C:
$48 000
1.1
= $40 000 + $43 636
= $3636
= $40 000 +
NPV
Accept Proposal A.
Internal rate of return
Proposal A:
$8 000 $48 000
1 r
(1 r ) 2
By trial and error, r = 20 per cent
NPV
= 0
= 40 000 +
Proposal B:
42 000
1 r
By trial and error, r = 5 per cent
NPV
= 0
= 40 000 +
Proposal C:
48 000
1 r
By trial and error, r, = 20 per cent
Accept Proposals A and C.
NPV
= 0 =
40 000 +
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3.
CHAPTER 5
(a) Accounting rate of return based on simple average of initial cost and residual value:
ra
= $30 000 20 000 100

$120 000
1
2
$10 000 100
$60 000 1
= 16.67 per cent
(b) Payback period = 3.33 years

(c) Internal rate of return:
$30 000 30 000 30 000 30 000 50 000
$100 000 =
1 r
( 1 r )2 ( 1 r )3 ( 1 r )4 ( 1 r )5
r
= 19 per cent
(d) Net present value:
NPV
=
=
=
$30 000
1
1
$20 000( 1.1 )5
5
0.1 ( 1.1 )
$100 000 + $113 724 + $12 418
$26 142
$100 000 +
If the net cash flows for each year were those given in the second part of the question,
the results would be:
(a) Accounting rate of return:
ra
$40 000 20 000 100
$120 000
1
2
$20 000 100
$60 000 1
33.33 per cent
(b) Payback period = 2.5 years

(c) Internal rate of return:
$30 000 40 000 60 000 20 000 70 000
100 000 =
1 r
( 1 r )2 ( 1 r )3 ( 1 r )4 ( 1 r )5
r
=
30 per cent
(d) Net present value:
NPV =
$100 000 + $30 000 (1.1)1 + $40 000 (1.1) 2 + $60 000 (1.1) 3
+ $20 000 (1.1) 4 + $70 000 (1.1) 5
=
$62 534
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4.
CHAPTER 5
(a) Accounting rate of return:

(i)
ra
average profit
100
average investment
1
$12 000
100
$40 000 + $8 000

1
2
(ii)
ra
$12 000 100
$24 000 1
50 per cent
$80 000 100
5
1
$40 000 8 000
2
$16 000 100
$24 000 1
66.67 per cent
(b) Payback period:

(i) Payback =
=
C
R
40 000
12 000
= 3.33 years
(ii) Payback = 2.5 years
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CHAPTER 5
5.
$200,000.00
$150,000.00
NPV(A)
$50,000.00
20.00%
18.00%
16.00%
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
-$50,000.00
NPV(B)
2.00%
$0.00
0.00%
NPV
$100,000.00
-$100,000.00
Discount rate
NPVA
$240 000
NPVB
140 000 80 000
(1.11)
(1.11)2
60 000 20 000 180 000
(1.11) 3 (1.11) 4 (1.11) 5
$19 971.05
$240 000
60 000 20 000 180 000
(1.11) 3 (1.11) 4 (1.11) 5

$27 048.73
20 000 40 000
(1.11) (1.11)2
Using the NPV method, Project B should be selected.

IRRA
= 15.78 per cent
IRRB
= 14.19 per cent
Using the IRR method, Project A should be selected.
The reasons for the different ranking of projects A and B under the NPV and IRR
methods are explained in Section 5.4.3. To maximise a companys value, the NPV
method should be used and therefore Project B should be selected.
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6.
CHAPTER 5
(a) Project A:
NPV = $97 400 +
$34 000
1
1
0.08 (1.08) 5
=
$38 351.08
Project B:
NPV =
=
$63 200 +
$24 000
1
1
0.08 (1 r ) 5
$32 624.80
Project A:
$44 000
1
IRR = $97 400 =
1
5
r
(1 r )
r = 22 per cent
Project B:
$24 000
1
IRR = $63 200 =
1
5
r = $26 per rcent (1 r )
(b) As in Example 5.4, the difference in ranking is due to the different scale of the
projects.
7.
Project A:
= $100 000 $140 000 (1.12)1 + $60 000 (1.12)2
= $100 000 $125 000 + $47 831
= $22 831
Project B:
NPV
NPV
=
=
=
$12 000 + $24 000 (1.12)1 $20 000 (1.12)2

$12 000 + $21 429 $15 944
$6 515
Project A:
$140000 $60000
(1 r )
( 1 r )2
There is no positive IRR. The two negative solutions are 65.6% and 274.4%.
IRR = $100 000 =
Project B:
$24000 $20000
( 1 r ) ( 1 r )2
There is no positive IRR. The two negative solutions are 36.7% and 363.3%.
IRR = $12 000 =
The internal rates of return for projects A and B are negative, whereas projects A and B
have net present values that are positive and negative respectively. This example
demonstrates possible problems with using the IRR method of project evaluation.
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Chapter 5

Project evaluation: principles and

Net present value

= $30 000 20 000 100

(b) Payback period = 3.33 years

$40 000 20 000 100

$20 000 100

33.33 per cent

(b) Payback period = 2.5 years

(a) Accounting rate of return:

$40 000 + $8 000

$12 000 100

$80 000 100

$16 000 100

66.67 per cent

(b) Payback period:

140 000 80 000

60 000 20 000 180 000

(1.11) 3 (1.11) 4 (1.11) 5

60 000 20 000 180 000

(1.11) 3 (1.11) 4 (1.11) 5

Using the NPV method, Project B should be selected.

$12 000 + $24 000 (1.12)1 $20 000 (1.12)2

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