Solutions to Tutorial week 2:

CQ5.4; QP5.12; QP5.16; QP6.10; QP6.14; QP6.18

Note: You might see small differences for some solutions, it is because I’m
using excel spread sheet and PVIFA formula to do the calculations. And you
may have a little bit different answers when you used calculator.

Chapter 5

CQ 5.4. A project has perpetual cash flows of C per period, a cost of I, and a
required return of R. What is the relationship between the project’s
payback and its IRR? What implications does your answer have for long-
lived projects with relatively constant cash flow?

Solution:

For a project with future cash flows that are an annuity:

Payback = I / C

And the IRR is:

0 = – I + C / IRR

Solving the IRR equation for IRR, we get:

IRR = C / I

Notice this is just the reciprocal of the payback. So:

IRR = 1 / PB
For long-lived projects with relatively constant cash flows, the sooner the
project pays back, the greater is the IRR, and the IRR is approximately equal to
the reciprocal of the payback period.
QP5.12. Problems with profitability index. The Robb Computer Corporation is
trying to choose between the following two mutually exclusive design
projects:
Year Cash Flow (I) Cash Flow (II)
0 -$30,000 -$12,000
1 18,000 7,500
2 18,000 7,500
3 18,000 7,500

a. If the required return is 10 percent and Robb Computer applies the

profitability index decision rule, which project should the firm accept?
b. If the company applies the NPV decision rule, which project should it take?
c. Explain why our answer in (a) and (b) are different?

Solution:
a. The profitability index is the PV of the future cash flows divided by the initial
investment. The cash flows for both projects are an annuity, so:

PII = $18,000(PVIFA10%,3 ) / $30,000 = 1.493

PIII = $7,500(PVIFA10%,3) / $12,000 = 1.555

The profitability index decision rule implies that we accept project II, since
PIII is greater than the PII.

b. The NPV of each project is:

NPVI = – $30,000 + $18,000(PVIFA10%,3) = $14,777.16

NPVII = – $12,000 + $7,500(PVIFA10%,3) = $6,657.15

The NPV decision rule implies accepting Project I, since the NPV I is
greater than the NPVII.

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 c. Using the profitability index to compare mutually exclusive projects can
be ambiguous when the magnitudes of the cash flows for the two projects
are of different scales. In this problem, project I is roughly 3 times as large
as project II and produces a larger NPV, yet the profit-ability index
criterion implies that project II is more acceptable.

QP5.16. Comparing investment criteria. Consider the following cash flows if two
mutually exclusive projects for AZ-Motorcars. Assume the discount rate
for AZ-Motorcars is 10 percent.
Year AZM Mini-SUV AZF Full-SUV
0 -$450,000 -$800,000
1 320,000 350,000
2 180,000 420,000
3 150,000 290,000

a. Based on the payback period, which project should be accepted?

b. Based on the NPV, which project should be accepted?
c. Based on the IRR, which project should be accepted?
d. Based on this analysis, is incremental IRR analysis necessary? If yes, please
conduct the analysis.

Solution:
a. The payback period is the time that it takes for the cumulative undiscounted
cash inflows to equal the initial investment.

AZM Mini-SUV:

Cumulative cash flows Year 1 = $320,000 = $320,000

Cumulative cash flows Year 2 = $320,000 + 180,000 = $500,000

Payback period = 1+ $130,000 / $180,000 = 1.72 years

AZF Full-SUV:

Cumulative cash flows Year 1 = $350,000 = $350,000

Cumulative cash flows Year 2 = $350,000 + 420,000 = $770,000
Cumulative cash flows Year 3=$350,000+420,000+290,000=$1,060,000

Payback period = 2+ $30,000 / $290,000 = 2.1 years

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 Since the AZM has a shorter payback period than the AZF, the company
should choose the AZM. Remember the payback period does not
necessarily rank projects correctly.

b. The NPV of each project is:

NPVAZM = –$450,000 + $320,000 / 1.10 + $180,000 / 1.102 + $150,000 /

1.103
NPVAZM = $102,366

NPVAZF = –$800,000 + $350,000 / 1.10 + $420,000 / 1.102 + $290,000 /

1.103
NPVAZF = $83,170

The NPV criteria implies we accept the AZM because it has the highest
NPV.

c. The IRR is the interest rate that makes the NPV of the project equal to
zero. So, the IRR of the AZM is:

0 = –$450,000 + $320,000 / (1 + IRR) + $180,000 / (1 + IRR)2 + $150,000 /

(1 + IRR)3

Using a spreadsheet, financial calculator, or trial and error to find the root
of the equation, we find that:

IRRAZM = 24.65%

And the IRR of the AZF is:

0 = –$800,000 + $350,000 / (1 + IRR) + $420,000 / (1 + IRR)2 + $290,000 /

(1 + IRR)3

Using a spreadsheet, financial calculator, or trial and error to find the root
of the equation, we find that:

IRRAZF = 15.97%

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 The IRR criteria implies we accept the AZM because it has the highest
IRR. Remember the IRR does not necessarily rank projects correctly.

d. Incremental IRR analysis is not necessary. The AZM has the smallest
initial investment, and the largest NPV, so it should be accepted.

5
Chapter 6

QP 6.10. Calculating EAC. You are evaluating two different silicon

wafer milling machines. The Techron I costs $215,000, has a three-
year life, and has pretax operating costs of $35,000 per year. The
Techron II costs $270,000, has a five-year life, and has pretax
operating costs of $44,000 per year. For both milling machines, use
straight-line depreciation to zero over the project’s life and assume a
salvage value of $20,000. If your tax rate is 35 percent and your
discount rate is 12 percent, compute the EAC for both machine.
Which do you prefer? Why

Solution:

We will need the aftertax salvage value of the equipment to compute the
EAC. Even though the equipment for each product has a different initial
cost, both have the same salvage value. The aftertax salvage value for
both is:

Both cases: aftertax salvage value = $20,000(1 – 0.35) = $13,000

To calculate the EAC, we first need the OCF and NPV of each option.
The OCF and NPV for Techron I is:

OCF = – $35,000(1 – 0.35) + 0.35($215,000/3) = $-

22,750+25,083=$2,333

NPV = –$215,000 + $2,333(PVIFA12%,3) + ($13,000/1.123) =

-215,000+5,603+9,253=-$200,144

EAC = –$200,144 / (PVIFA12%,3) = –$83,329

And the OCF and NPV for Techron II is:

OCF = – $44,000(1 – 0.35) + 0.35($270,000/5) = –$28,600+18,900=-

$9,700

NPV = –$270,000 – $9,700(PVIFA12%,5) + ($13,000/1.125) =

-270,000-34,966+7377=-$297,589

EAC = –$297,589 / (PVIFA12%,5) = –$82,554

6
 The two milling machines have unequal lives, so they can only be
compared by expressing both on an equivalent annual basis, which is
what the EAC method does. Thus, you prefer the Techron II because
it has the lower (less negative) annual cost.

QP6.14. Comparing mutually exclusive projects. Vandalay Industries

is considering the purchase of a new machine for the production of
latex. Machine A costs $2,900,000 and will last for six years. Variable
costs are 35 percent of sales, and fixed costs are $195,000 per year.
Machine B costs $5,700,000 and will last for nine years. Variable
costs for this machine are 30 percent and fixed costs are $165,000 per
year. The sales for each machine will be $12 million per year. The
required return is 10 percent and the tax rate is 35 percent. Both
machines will be depreciated on a straight-line basis. If the company
plans to replace the machine when it wears out on a perpetual basis,
which machine should you choose?

Solution:
Since we need to calculate the EAC for each machine, sales are
irrelevant. EAC only calculates the costs of operating the equipment,
not the sales. Using the bottom up approach, or net income plus
depreciation, method to calculate OCF, we get:

Machine A Machine B
Variable costs –$4,200,000 –$3,600,000
Fixed costs –195,000 –165,000
Depreciation –483,333 –633,333
EBT –$4,878,333 –$4,398,333
Tax 1,707,417 1,539,417
Net income –$3,170,916 –$2,858,916
+ Depreciation 483,333 633,333
OCF –$2,687,583 –$2,225,583

The NPV and EAC for Machine A is:

NPVA = –$2,900,000 – $2,687,583(PVIFA10%,6)

NPVA = –$14,605,123

EACA = – $14,605,123 / (PVIFA10%,6)

EACA = –$3,353,445

And the NPV and EAC for Machine B is:

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 NPVB = –$5,700,000 – 2,225,583(PVIFA10%,9)
NPVB = –$18,517,133

EACB = – $18,517,133 / (PVIFA10%,9)

EACB = –$3,215,338

You should choose Machine B since it has a less negative EAC.

QP6.18. Cash flow valuation. Phillips Industries runs a small

manufacturing operation. For this fiscal year, it expects real net cash
flows of $190,000. Phillips is an ongoing operation but it expects
competitive pressures to erode its real net cash flows at 4 percent per
year in perpetuity. The appropriate real discount rate for Phillips is 11
percent. All net cash flows are received at year-end. What is the
present value of the net cash flows from Phillips’s operations?

Solution:

The present value of the company is the present value of the future cash
flows generated by the company. Here we have real cash flows, a real
interest rate, and a real growth rate. The cash flows are a growing
perpetuity, with a negative growth rate. Using the growing perpetuity
equation, the present value of the cash flows are:

PV = C1 / (R – g)
PV = $190,000 / [.11 – (–.04)]
PV = $1,266,667

Chapter 7: QP7.1, QP7.4, QP7.8. Chapter 10: QP10.18, QP10.20,

QP10.23.

Chapter 7

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QP 7.1. Sensitivity analysis and break-even point. We are evaluating a
project that costs $644,000, has an eight-year life, and has no
salvage value. Assume that depreciation is straight-line to zero
over the life of the project. Sales are projected at 70,000 units per
year. Price per unit is $37, variable cost per unit is $21, and fixed
costs are $725,000 per year. The tax rate is 35 percent, and we
require a 15 percent return on this project.
a. Calculate the accounting break-even point.
b. Calculate the base-case cash flow and NPV. What is the sensitivity
of NPV to changes in the sales figure? Explain what your answer
tells you about a 500-unit decrease in projected sales.
c. What is the sensitivity of OCF to changes in the variable cost
figure? Explain what your answer tells you about a $1 decrease in
estimated variable costs.

a. To calculate the accounting breakeven (when Net Income=0), we first

need to find the depreciation for each year. The depreciation is:

Depreciation = $644,000/8
Depreciation = $80,500 per year

And the accounting breakeven is: (P-v) QA-FC-D=NI=0

QA = ($725,000 + 80,500)/($37 – 21)

QA = 50,344 units

b. We will use the tax shield approach to calculate the OCF. The
OCF is:

OCFbase = [(P – v)Q – FC](1 – tc) + tcD

OCFbase = [($37 – 21)(70,000) – $725,000](0.65) + 0.35($80,500)
OCFbase = $284,925

Now we can calculate the NPV using our base-case projections.

There is no salvage value or NWC, so the NPV is:

NPVbase = –$644,000 + $284,925(PVIFA15%,8)

NPVbase = $634,550.08

To calculate the sensitivity of the NPV to changes in the quantity

sold, we will calculate the NPV at a different quantity. We will
use sales of 71,000 units (you can create any new level as you

9
 like, e.g., 80,000 units, 69,000 units or whatever, it won’t affect
the sensitivity analysis). The OCF at this sales level is:

OCFnew = [($37 – 21)(71,000) – $725,000](0.65) + 0.35($80,500)

OCFnew = $295,325

And the NPV is:

NPVnew = –$644,000 + $295,325(PVIFA15%,8)

NPVnew = $681,218.22

So, the change in NPV for every unit change in sales is:

NPV/S = ($634,550.08 – 681,218.22)/(70,000 – 71,000)

NPV/S = +$46.668

If sales were to drop by 500 units, then NPV would drop by:

NPV drop = $46.668(500) = $23,334.07

You may wonder why we chose 71,000 units. Because it doesn’t

matter! Whatever sales number we use, when we calculate the
change in NPV per unit sold, the ratio will be the same.

c. To find out how sensitive OCF is to a change in variable costs,

we will compute the OCF at a variable cost of $22. Again, the
number we choose to use here is irrelevant: We will get the same
ratio of OCF to a one dollar change in variable cost no matter
what variable cost we use. So, using the tax shield approach, the
OCF at a variable cost of $22 is:

OCFnew = [($37 – 22)(70,000) – 725,000](0.65) + 0.35($80,500)

OCFnew = $239,425

So, the change in OCF for a $1 change in variable costs is:

OCF/v = ($284,925 – 239,425)/($21 – 22)

OCF/v = –$45,500

If variable costs decrease by $1 then, OCF would increase by

$45,500

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QP 7.4. Financial break-even. L.J.’s Toys Inc. just purchased a $390,000
machine to produce toy cars. The machine will be fully depreciated
by the straight-line method over its five-year economic life. Each toy
sells for $25. The variable cost per toy is $11, and the firm incurs
fixed costs of $280,000 each year. The corporate tax rate for the
company is 34 percent. The appropriate discount rate is 12 percent.
What is the financial break-even point for the project?

When calculating the financial breakeven point (when NPV=0), we

express the initial investment as an equivalent annual cost (EAC).
Dividing the initial investment by the five-year annuity factor,
discounted at 12 percent, the EAC of the initial investment is:

EAC = Initial Investment / PVIFA12%,5

EAC = $390,000 / 3.60478
EAC = $108,189.80

Note that this calculation solves for the annuity payment with the
initial investment as the present value of the annuity. In other words:

PVA = C({1 – [1/(1 + R)]t } / R)

$390,000 = C{[1 – (1/1.12)5 ] / .12}
C = $108,189.80

The annual depreciation is the cost of the equipment divided by the

economic life, or:

Annual depreciation = $390,000 / 5

Annual depreciation = $78,000

Now we can calculate the financial breakeven point. The financial

breakeven point for this project is:

QF = [EAC + FC(1 – tc) – D(tc)] / [(P – VC)(1 – tc)]

QF = [$108,189.80 + $280,000(1 – 0.34) – $78,000(0.34)] / [($25 –
11)(1 – 0.34)]
QF = 28,838.72 or about 28,839 units

QP 7.8. Decision trees. B&B has a new baby powder ready to market. If
the firm goes directly to the market with the product, there is only a 55
percent chance of success. However, the firm can conduct customer

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segment research, which will take a year and cost $1.2 million. By going
through research, B&B will be able to better target potential customers
and will increase the probability of success to 70 percent. If successful,
the baby powder will bring a present value profit (at time of initial
selling) of $19 million. If unsuccessful, the present value payoff is only
$6 million. Should the firm conduct customer segment research or go
directly to market? The appropriate discount rate is 15 percent.

The company should analyze both options, and choose the option with the
greatest NPV. So, if the company goes to market immediately, the
NPV is:

NPV = CSuccess (Prob. of Success) + CFailure (Prob. of Failure)

NPV = $19,000,000(.55) + $6,000,000(.45)
NPV = $13,150,000

Customer segment research requires a $1.2 million cash outlay.

Choosing the research option will also delay the launch of the product
by one year. Thus, the expected payoff is delayed by one year and
must be discounted back to Year 0. So, the NPV of the customer
segment research is:

NPV= C0 + {[CSuccess (Prob. of Success)] + [CFailure (Prob. of Failure)]} /

(1 + R)t
NPV = –$1,200,000 + {[$19,000,000 (0.70)] + [$6,000,000 (0.30)]} /
1.15
NPV = $11,930,434.78
The company should go to market now since it has the largest NPV

Graphically, the decision tree for the project is:

Success
$19 million at t = 1
Research
$11.93 million at t = 0
Failure
Start $6 million at t = 1

Success
No Research $19 million at t = 0
$13.15 million at t = 0
Failure
$6 million at t = 0

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Chapter 10

QP 10. 18. Refer back to Table 10.2. What range of returns would you
expect to see 68 percent of the time for large-company stocks? What
about 95 percent of the time?

Looking at the large-company stock return history in Table 10.2, we see

that the mean return was 11.8 percent, with a standard deviation of
20.3 percent. The range of returns you would expect to see 68 percent
of the time is the mean plus or minus 1 standard deviation, or:

RÎ m ± 1s = 11.8% ± 20.3% = –8.50% to 32.10%

The range of returns you would expect to see 95 percent of the time is
the mean plus or minus 2 standard deviations, or:

RÎ m ± 2s = 11.8% ± 2(20.3%) = –28.80% to 52.40%

QP 10. 20. A stock has had returns of 27 percent, 12 percent, 32 percent,

-12 percent, 19 percent, and -31 percent over the last six years. What are
the arithmetic and geometric returns for the stock?

The arithmetic average return is the sum of the known returns divided by
the number of returns, so:

Arithmetic average return = (.27 + .12 + .32 –.12 + .19 –.31) / 6

Arithmetic average return = .0783, or 7.83%

Using the equation for the geometric return, we find:

Geometric average return = [(1 + R1) × (1 + R2) × … × (1 + RT)]1/T – 1

Geometric average return = [(1 + .27)(1 + .12)(1 + .32)(1 – .12)(1 + .
19)(1 – .31)](1/6) – 1
Geometric average return = .0522, or 5.22%

Remember, the geometric average return will always be less than the
arithmetic average return if the returns have any variation. If the
13
 returns are constant for each period the geometric average will be
equalled to arithmetic average.

QP 10. 23. You bought one of Bergen Manufacturing Co.’s 7 percent

coupon bonds one year ago for $1,080.50. These bonds make annual
payments and mature six years from now. Suppose you decide to sell
your bonds today when the required return on the bonds is 5.5
percent. If the inflation rate was 3.2 percent over the past year, what
would be your total real return on the investment?

To find the return on the coupon bond, we first need to find the price of
the bond today. Since one year has elapsed, the bond now has six
years to maturity, so the price today is:

P1 = $70(PVIFA5.5%,6) + $1,000/1.0556
P1 = $1,074.93

You received the coupon payments on the bond, so the nominal return
was:

R = ($1,074.93 – 1,080.50 + 70) / $1,080.50

R = .0596, or 5.96%

And using the Fisher effect equation to find the real return, we get:

r = (1.0596 / 1.032) – 1
r = .0268, or 2.68%

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