Professional Documents
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CHAPTER OUTLINE
I.
2.
Although this measure does, in fact, deal with cash flows and is easy to
calculate and understand, it ignores any cash flows that occur after the
payback period and does not consider the time value of money within
the payback period.
3.
To deal with the criticism that the payback period ignores the time
value of money, some firms use the discounted payback period
method. The discounted payback period method is similar to the
traditional payback period except that it uses discounted free cash
flows rather than actual undiscounted free cash flows in calculating the
payback period.
4.
226
B.
Present-value methods
1.
NPV
t 1
FCFt
(1 k) t
- IO
where:
a.
FCFt =
IO
b.
2.
The profitability index is the ratio of the present value of the expected
future free cash flows to the initial cash outlay, or
n
profitability index =
a.
t 1
FCFt
(1 k) t
IO
b.
The advantages of this method are the same as those for the
net present value.
c.
227
C.
The internal rate of return is the discount rate that equates the present value of
the project's future net cash flows with the project's initial outlay. Thus the
internal rate of return is represented by IRR in the equation below:
n
IO =
t 1
1.
FCFt
(1 IRR) t
2.
The advantages of this method are that it deals with cash flows and
recognizes the time value of money; however, the procedure is rather
complicated and time-consuming. The net present value profile allows
you to graphically understand the relationship between the internal rate
of return and NPV. A net present value profile is simply a graph
showing how a projects net present value changes as the discount rate
changes. The IRR is the discount rate at which the NPV equals zero.
3.
The primary drawback of the internal rate of return deals with the
reinvestment rate assumption it makes. The IRR implicitly assumes
that the cash flows received over the life of the project can be
reinvested at the IRR while the NPV assumes that the cash flows over
the life of the project are reinvested at the required rate of return.
Since the NPV makes the preferred reinvestment rate assumption it is
the preferred decision technique. The modified internal rate of return
(MIRR) allows the decision maker the intuitive appeal of the IRR
coupled with the ability to directly specify the appropriate
reinvestment rate.
a.
To calculate the MIRR we take all the annual free tax cash
inflows, ACIFt's, and find their future value at the end of the
project's life compounded at the required rate of return - this is
called the terminal value or TV. All cash outflows, ACOFt, are
then discounted back to present at the required rate of return.
The MIRR is the discount rate that equates the present value of
the free cash outflows with the present value of the project's
terminal value.
b.
228
ANSWERS TO
END-OF-CHAPTER QUESTIONS
9-1.
Capital budgeting decisions involve investments requiring rather large cash outlays at
the beginning of the life of the project and commit the firm to a particular course of
action over a relatively long time horizon. As such, they are costly and difficult to
reverse, both because of: (1) their large cost and (2) the fact that they involve fixed
assets, which cannot be liquidated easily.
9-2.
The criticisms of using the payback period as a capital budgeting technique are:
(1)
(2)
(3)
It ignores the timing of the free cash flows that occur during the payback
period.
It ignores all free cash flows occurring after the payback period.
The selection of the maximum acceptable payback period is arbitrary.
It deals with cash flows rather than accounting profits, and therefore focuses
on the true timing of the project's benefits and costs.
It is easy to calculate and understand.
It can be used as a rough screening device, eliminating projects whose returns
do not materialize until later years.
These final two advantages are the major reasons why it is used frequently.
9-3.
Yes. The payback period eliminates projects whose returns do not materialize until
later years and thus emphasizes the earliest returns, which in a country experiencing
frequent expropriations would certainly have the most amount of uncertainty
surrounding the later returns. In this case, the payback period could be used as a
rough screening device to filter out those riskier projects, which have long lives.
9-4.
The three, discounted cash flow capital budgeting criteria are the net present value,
the profitability index, and the internal rate of return. The net present value method
gives an absolute dollar value for a project by taking the present value of the benefits
and subtracting out the present value of the costs. The profitability index compares
these benefits and costs through division and comes up with a measure of the project's
relative valuea benefit/cost ratio. On the other hand, the internal rate of return tells
us the rate of return that the project earns. In the capital budgeting area, these
methods generally give us the same accept-reject decision on projects but many times
rank them differently. As such, they have the same general advantages and
disadvantages, although the calculations associated with the internal rate of return
method can become quite tedious and it assumes cash flows over the life of the life of
the project are reinvested at the IRR. The advantages associated with these
discounted cash flow methods are:
(1)
They deal with cash flows rather than accounting profits.
(2)
They recognize the time value of money.
(3)
They are consistent with the firm's goal of shareholder wealth maximization.
229
9-5
The advantage of using the MIRR, as opposed to the IRR technique is that the MIRR
technique allows the decision maker to directly input the reinvestment rate
assumption. With the IRR method it is implicitly assumed that the cash flows over the
life of the project are reinvested at the IRR.
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
9-1A. (a)
(b)
(c)
(d)
9-2A. (a)
(b)
IO
$10,000
0.582
PVIFIRR%,8 yrs
Thus, IRR
7%
$10,000
0.208
PVIFIRR%,10 yrs
Thus, IRR
17%
$10,000
0.087
PVIFIRR%,20 yrs
Thus, IRR
13%
$10,000
.731
PVIFIRR%,3 yrs
Thus, IRR
11%
I0
$10,000
5.018
PVIFAIRR%,10 yrs
Thus, IRR
15%
$10,000
4.869
PVIFAIRR%,20 yrs
Thus, IRR
20%
230
(c)
(d)
9-3A. (a)
$10,000
8.382
PVIFAIRR%,12 yrs
Thus, IRR
6%
$10,000
3.517
PVIFAIRR%,5 yrs
Thus, IRR
13%
$10,000
$2,000
1
(1 IRR)
$5,000
(1 IRR)
$8,000
(1 IRR)3
Try 18%:
$10,000
$10,156
$9,954
Thus, IRR
approximately 19%
$10,000
Try 19%
$10,000
(b)
$8,000
1
(1 IRR)
$5,000
(1 IRR)
$2,000
(1 IRR)3
Try 30%
$10,000
$10,022
$9,909
approximately 30%
Try 31%:
$10,000
Thus, IRR
231
(c)
$10,000
$2,000
t 1
(1 IRR)
$5,000
(1 IRR )6
Try 11%
$10,000
$7,392 + $2,675
$10,067
$7,210 + $2,535
$9,745
Thus, IRR
approximately 11%
NPV
Try 12%
$10,000
9-4A. (a)
(b)
(c)
(d)
$450,000
t 1
(1 .09) t
- $1,950,000
$2,018,700
$1,950,000
1.0352
$1,950,000
4.333
PVIFAIRR%,6 yrs
IRR
PI
232
9-5A. (a)
PVIF10%,n
-$80,000
20,000
20,000
20,000
20,000
20,000
20,000
1.000
.909
.826
.751
.683
.621
.564
Year
Undiscounted
Cash Flows
0
1
2
3
4
5
6
Discounted
Cash Flows
Cumulative
Discounted
Cash Flows
-$80,000
18,180
16,520
15,020
13,660
12,420
11,280
(c)
(d)
9-6A. (a)
NPV
$20,000
t 1
(1 .10) t
- $80,000
$87,100
$80,000
1.0888
$80,000
4.000
PVIFAIRR%,6 yrs
IRR
NPVA
PI
NPVB
$12,000
t 1
(1 .12) t
- $50,000
$13,000
t 1
(1 .12) t
- $70,000
233
-$80,000
-61,820
-45,300
-30,280
-16,620
-4,200
7,080
(b)
$49,332
$50,000
0.9866
$53,443
$70,000
0.7635
$50,000
4.1667
PVIFAIRR%,6 yrs
IRRA
11.53%
$70,000
5.3846
PVIFAIRR%,6 yrs
IRRB
3.18%
PIA
PIB
(c)
Project A:
Payback Period = 2 years + $100/$200 = 2.5 years
Project A:
Discounted Payback Period Calculations:
Year
0
1
2
3
4
5
Undiscounted
Cash Flows PVIF10%,n
-$1,000
600
300
200
100
500
1.000
.909
.826
.751
.683
.621
234
Discounted
Cash Flows
-$1,000
545
248
150
68
311
Cumulative
Discounted
Cash Flows
-$1,000
-455
-207
-57
11
322
Year
Undiscounted
Cash Flows PVIF10%,n
Discounted
Cash Flows
Cumulative
Discounted
Cash Flows
0
1
-$10,000
5,000
1.000
.909
-$10,000
4,545
-$10,000
-5,455
2
3
4
5
3,000
3,000
3,000
3,000
.826
.751
.683
.621
2,478
2,253
2,049
1,863
-2,977
-724
1,325
3,188
Undiscounted
Cash Flows
-$5,000
1,000
1,000
2,000
2,000
2,000
PVIF10%,n
Discounted
Cash Flows
1.000
.909
.826
.751
.683
.621
-$5,000
909
826
1,502
1,366
1,242
235
Cumulative
Discounted
Cash Flows
-$5,000
-4,091
-3,265
-1,763
-397
845
9-8A. NPV9%
NPV11%
NPV13%
NPV15%
Project
Traditional Payback
Discounted Payback
Accept
Reject
Accept
Reject
Reject
Reject
$1,000,000
t 1
(1 .09) t
- $5,000,000
$1,000,000
t 1
(1 .11) t
- $5,000,000
$1,000,000
- $5,000,000
t 1 (1 .13)t
$1,000,000
t 1
(1 .15) t
- $5,000,000
9-9A. Project A:
$50,000
$10,000
1
(1 IRR A )
$15,000
(1 IRR A )
$25,000
(1 IRR A )
236
$20,000
(1 IRR A )3
$30,000
(1 IRR A )5
Try 23%
$50,000
$50,360
Try 24%
$50,000
+ $25,000(.423) + $30,000(.341)
=
$49,095
$100,000
4.00
PVIFAIRR%,5 yrs
Thus, IRR
8%
$450,000
2.25
PVIFAIRR%,3 yrs
Thus, IRR
16%
Thus, IRR
Project B:
Project C:
9-10A. (a)
(b)
NPV
NPV
$18,000
t 1
(1 .10) t
- $100,000
$18,000(6.145) - $100,000
$110,610 - $100,000
$10,610
=
=
=
=
(c)
10
10
$18,000
t 1
(1 .15) t
- $100,000
$18,000(5.019) - $100,000
$90,342 - $100,000
-$9,658
If the required rate of return is 10% the project is acceptable as in part (a).
237
(d)
9-11A. (a)
$100,000
5.5556
IRR
ACOFt
t 0
(1 k) t
$10,000,000 =
$10,000,000 =
$10,000,000 =
MIRR
(b)
$10,000,000 =
$10,000,000 =
$10,000,000 =
MIRR
(c)
$10,000,000 =
$10,000,000 =
$10,000,000 =
MIRR
t0
ACIFt (1 k) n t
(1 MIRR)n
$3,000,000(FVIFA10%10years )
(1 MIRR)10
$3,000,000(15.937)
(1 MIRR )10
$47,811,000
(1 MIRR )10
16.9375%
$3,000,000(FVIFA12%10years )
(1 MIRR)10
$3,000,000(17.549)
(1 MIRR )10
$52,647,000
(1 MIRR )10
18.0694%
$3,000,000( FVIFA14%10 years )
(1 MIRR )10
$3,000,000(19.337)
(1 MIRR )10
$58,011,000
(1 MIRR )10
19.2207%
238
Capital budgeting decisions involve investments requiring rather large cash outlays at
the beginning of the life of the project and commit the firm to a particular course of
action over a relatively long time horizon. As such, they are both costly and difficult
to reverse, both because of: (1) their large cost; (2) the fact that they involve fixed
assets which cannot be liquidated easily.
2.
3.
Payback periodA
= 3 years +
Payback PeriodB
20,000
years
50,000
110,000
years
40,000
3.4 years
2.75 years
The disadvantages of the payback period are: 1) ignores the time value of money,
2)ignores cash flows occurring after the payback period, 3)selection of the maximum
acceptable payback period is arbitrary.
5.
Undiscounted
Cash Flows
PVIF12%,n
-$110,000
20,000
30,000
40,000
50,000
70,000
1.000
.893
.797
.712
.636
.567
Discounted
Cash Flows
-$110,000
17,860
23,910
28,480
31,800
39,690
239
Cash Flows
-$110,000
-92,140
-68,230
-39,750
-7,950
31,740
Year
0
1
2
3
4
5
Undiscounted
Cash Flows
PVIF12%,n
-$110,000
40,000
40,000
40,000
40,000
40,000
1.000
.893
.797
.712
.636
.567
Discounted
Cash Flows
Cumulative
Discounted
Cash Flows
-$110,000
35,720
31,880
28,480
25,440
22,680
-$110,000
-74,280
-42,400
-13,920
11,520
34,200
The major problem with the discounted payback period comes in setting the firm's
maximum desired discounted payback period. This is an arbitrary decision that affects
which projects are accepted and which ones are rejected. Thus, while the discounted
payback period is superior to the traditional payback period, in that it accounts for the
time value of money in its calculations, its use should be limited due to the problem
encountered in setting the maximum desired payback period. In effect, neither
method should be used.
7.
NPVA
t 1
FCFt
(1 k) t
- IO
NPVB
$141,740-$110,000
$31,740
$40,000(3.605) - $110,000
$144,200-$110,000
$34,200
240
8.
The net present value technique discounts all the benefits and costs in terms of cash
flows back to the present and determines the difference. If the present value of the
benefits outweighs the present value of the costs, the project is accepted, if not, it is
rejected.
9.
PIA
FCFt
t 1
(1 k)
IO
PIB
$141,740
$110 ,000
1.2885
$144,200
$110,000
1.3109
The net present value and the profitability index always give the same accept reject
decision. When the present value of the benefits outweighs the present value of the
costs the profitability index is greater than one, and the net present value is positive.
In that case, the project should be accepted. If the present value of the benefits is less
than the present value of the costs, then the profitability index will be less than one,
and the net present value will be negative, and the project will be rejected.
11.
For both projects A and B all of the costs are already in present dollars and, as such,
will not be affected by any change in the required rate of return or discount rate. All
the benefits for these projects are in the future and thus when there is a change in the
required rate of return or discount rate their present value will change. If the required
rate of return increased, the present value of the benefits would decline which would
in turn result in a decrease in both the net present value and the profitability index for
each project.
12.
IRRA
20.9698%
IRRB
23.9193%
13.
The required rate of return does not change the internal rate of return for a project,
but it does affect whether a project is accepted or rejected. The required rate of
return is the hurdle rate that the project's IRR must exceed in order to accept the
project.
14.
The net present value assumes that all cash flows over the life of the project are
reinvested at the required rate of return, while the internal rate of return implicitly
assumes that all cash flows over the life of the project are reinvested over the
remainder of the project's life at the IRR. The net present value method makes the
most acceptable, and conservative assumption and thus is preferred.
15.
Project A:
241
ACOFt
t 0
(1 k) t
$110,000
$110,000
t 0
ACIFt (1 k) n t
(1 MIRR) n
$20,000(1.574) $30,000(1.405)
$40,000(1.254) $50,000(1.120) $70,000
(1 MIRR A ) 5
$110,000
=
$31,480 $42,150 $50,160 $56,000 $70,000
(1 MIRR A ) 5
$249,790
$110,000
(1 MIRR A )5
MIRRA
17.8247%
Project B:
$40,000(FVIFA12%,5years )
$110,000
$110,000
$110,000
(1 MIRR B )5
MIRRB
18.2304%
(1 MIRR B )5
$40,000(6.353)
(1 MIRR B )5
$254,120
Both projects should be accepted because their MIRR exceeds the required rate of return.
The modified internal rate of return is superior to the internal rate of return method because
MIRR assumes the reinvestment rate of cash flows is the required rate of return.
242
(b)
(c)
(d)
9-2B. (a)
(b)
(c)
(d)
IO
$10,000
0.502
PVIFIRR%,8 yrs
Thus, IRR
9%
$10,000
0.497
PVIFIRR%,12 yrs
Thus, IRR =
6%
$10,000
0.083
PVIFIRR%,22 yrs
Thus, IRR
12%
$10,000
0.519
PVIFIRR%,5 yrs
Thus, IRR
14%
IO
$10,000
4.66
PVIFAIRR%,10 yrs
Thus, IRR
17%
$10,000
5.102
PVIFAIRR%,20 yrs
Thus, IRR
19%
$10,000
7.163
PVIFAIRR%,12 yrs]
Thus, IRR
9%
$10,000
3.128
PVIFAIRR%,5 yrs
Thus, IRR
18%
243
9-3B. (a)
$10,000
$3,000
(1 IRR)
$5,000
(1 IRR)
$7,500
(1 IRR)3
Try 21%:
$10,000
$10,123
$9,952.50
Thus, IRR
approximately 22%
$12,000
Try 22%
$10,000
(b)
$9,000
1
(1 IRR)
$6,000
(1 IRR)
$2,000
(1 IRR)3
Try 25%
$12,000
$12,064
$11,926
Thus, IRR
$8,000
Try 26%:
$12,000
(c)
t 1
$2,000
(1 IRR) t
$5,000
(1 IRR)6
Try 18%
$8,000
$6,254 + $1,850
$8,104
$6,116 + $1,760
$7,876
Try 19%
$8,000
Thus, IRR
244
9-4B. (a)
(b)
(c)
(d)
9-5B. (a)
(b)
(c)
(d)
9-6B. (a)
NPV
PI
$750,000
t 1
(1 .11) t
- $2,500,000
$3,173,250 - $2,500,000
$673,250
$3,173,250
$2,500,000
1.2693
$2,500,000 =
3.333
PVIFAIRR%,6 yrs
IRR
$40,000
t 1
(1 .10) t
- $160,000
$174,200
$160,000
1.0888
$160,000
4.000
PVIFAIRR%,6 yrs
IRR
NPVA
PI
NPVB
(b)
PIA
$12,000
t 1
(1 .12) t
- $45,000
$14,000
t 1
(1 .12) t
- $70,000
$49,332
$45,000
245
1.0963
$57,554
$70,000
0.822
$45,000
3.75
PVIFAIRR%,6 yrs
IRRA
15.34%
$70,000
5.0000
PVIFAIRR%,6 yrs
IRRB
5.47%
PIB
(c)
Project A:
Payback Period
2 years
Project B:
Payback Period
Project C:
Payback Period
9-8B. NPV9%
Project
Accept
Accept
Reject
$2,500,000
t 1
(1 .09) t
- $10,000,000
NPV11% =
$2,500,000
t 1
(1 .11) t
- $10,000,000
NPV13% =
$2,500,000
t 1
(1 .13) t
- $10,000,000
246
NPV15% =
9-9B.
$2,500,000
t 1
(1 .15) t
- $10,000,000
Project A:
$75,000
$10,000
1
(1 IRR A )
$10,000
(1 IRR A )
$25,000
(1 IRR A )
$30,000
(1 IRR A )3
$30,000
(1 IRR A )5
Try 10%
$75,000
$75,585
Try 11%
$75,000
+ $25,000(.659) + $30,000(.593)
=
$73,325
Thus, IRR
$95,000
3.80
PVIFAIRR%,5 yrs
Thus, IRR
2.633
PVIFAIRR%,3 yrs
Thus, IRR
just below 7%
Project B:
Project C:
$395,000
10
9-10B. (a)
NPV
t 1
$25,000
- $150,000
(1 .09) t
$25,000(6.418) - $150,000
247
(b)
NPV
$160,450 - $150,000
$10,450
10
$25,000
t 1
(1 .15) t
- $150,000
$25,000(5.019) - $150,000
$125,475 - $150,000
-$24,525
(c)
(d)
$150,000 =
6.000
PVIFAIRR%,10 yrs
IRR
9-11B. (a)
b)
c)
ACOFt
t 0
(1 k) t
$8,000,000
$8,000,000
$8,000,000
MIRR
$8,000,000
$8,000,000
$8,000,000
MIRR
$8,000,000
$8,000,000
n-t
ACIFt (1 k)
t 0
(1 MIRR) n
$2,000,000(FVIFA10%,8years )
(1 MIRR)8
$2,000,000(11.436)
(1 MIRR)8
$22,872000
(1 MIRR)8
14.0320%
$2,000,000(FVIFA12%,8years )
(1 MIRR)8
$2,000,000(12.300)
(1 MIRR)8
$24,600,000
(1 MIRR)8
15.0749%
$2,000,000(FVIFA14%,8years )
(1 MIRR)8
$2,000,000(13.233)
(1 MIRR)8
248
$8,000,000
MIRR
$26,466,000
(1 MIRR)8
16.1312%
FORD'S PINTO
(Ethics in Capital Budgeting)
OBJECTIVE:
To force the students to recognize the role ethical behavior plays in all
areas of Finance.
DEGREE OF DIFFICULTY:
Easy
Case Solution:
With ethics cases there are no right or wrong answers - just opinions. Try to bring
out as many opinions as possible without being judgmental.
249