Solutions to Chapter 7

NPV and Other Investment Criteria

5. No. Even though project B has the higher IRR, its NPV is lower than that of project
A when the discount rate is lower (as in Problem 1) and higher when the discount
rate is higher (as in Problem 3). This example shows that the project with the higher
IRR is not necessarily better. The IRR of each project is fixed, but as the discount
rate increases, project B becomes relatively more attractive compared to project A.
This is because B’s cash flows come earlier, so their present values fall less rapidly
when the discount rate increases.

6. The profitability indexes are as follows:

Project A24.10/100 = .2410

Project B 22.19/100 = .2219

In this case, with equal initial investments, both the profitability index and NPV will
give projects the same ranking. This is an unusual case, however, since it is rare for
initial investments to be equal.

7. Project A has a payback period of 100/40 = 2.5 years. Project B has a payback
period of 2 years.
8. Project A

Discounted Cash Flow Cumulative Discounted

Year Cash Flow ($)
($) @ 11 percent Cash Flow ($)
0 -100 -100 -100
1 40 36.04 -63.96
2 40 32.48 -31.48
3 40 29.24 -2.24
4 40 26.36 +24.12
NPV= 24.12

Assuming uniform cash flows across time, the fractional year can now be
determined. Since the discounted cash flows are negative until year 3 and become
positive by Year 4, the project pays back sometime in the fourth year. Note that out
of the total discounted cash flow of $26.36 in Year 4, the first $2.24 comes in by
2.24/26.36 = 0.084 year. Therefore, the discounted payback period for Project A is
3.084 years.

Project B

Discounted Cash Flow Cumulative Discounted

Year Cash Flow ($)
($) @ 11 percent Cash Flow ($)

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 0 -100 -100 -100
1 50 45.05 -54.95
2 50 40.60 -14.35
3 50 36.55 +22.20
NPV= 22.20

The discounted payback for Project B is 2 years + 14.35/36.55 = 2.39 years.

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11. NPV = 3,000 + 800  annuity factor(10%, 6 years) = $484.21

At this discount rate, you should accept the project.

You can solve for IRR by setting the PV of cash flows equal to 3,000 on your
calculator and solving for the interest rate: PV = 3000; n = 6; FV = 0; PMT = 800;
compute i. The IRR is 15.34%, which is the highest discount rate before project
NPV turns negative.

14. Project at 2 percent discount rate

Discounted Cash Flow Cumulative Discounted

Year Cash Flow ($)
($) @ 2 percent Cash Flow ($)
0 -3000 -3000 -3000
1 800 784 -2216
2 800 768.8 -1447.2
3 800 753.6 -693.6
4 800 739.2 45.6
5 800 724.8 770.4
6 800 710.4 1480.8
NPV= 1480.8
Since the discounted cash flows become positive by Year 4, the project pays back
sometime in the fourth year. Note that out of the total discounted cash flow of
$739.20 in Year 4, the first $693.60 comes in by 693.60/739.20 = 0.94 year.
Therefore, the discounted payback for the project is 3.94 years, and thus the project
should be pursued.

Project at 12 percent discount rate

Discounted Cash Flow Cumulative Discounted

Year Cash Flow ($)
($) @ 12 percent Cash Flow ($)
0 -3000 -3000 -3000
1 800 714.4 -2285.6
2 800 637.6 -1648.0
3 800 569.6 -1078.4
4 800 508.8 -569.6
5 800 453.6 -116.0
6 800 405.6 289.6
NPV= 289.6

Since the discounted cash flows become positive by Year 6, the project pays back in
5 years + 116/405.6 = 5.28 years. Therefore, given the firm’s decision criteria of a
discounted payback of 5 years or less, the project should not be pursued.

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 As illustrated by the two scenarios above, the firm’s decision will change as the
discount rate changes. As the discount rate increases, the discounted payback period
gets extended.

 7,500  8,500
19. NPV = 10,000 + + = $-2,029.08
1.12 2 1.12 3

which is negative. So the project is not attractive.

However, you can note that the IRR of the project is 37.03 %. Since the IRR of the project
is greater than the required rate of return of 12%, the project should be accepted using this
rule. On balance, we would use the NPV rule and reject the project.

20. NPV9% = –20,000 + 4,000  annuity factor(9%, 8 periods)

= $2139.28

NPV14% = –20,000 + 4,000  annuity factor(14%, 8 periods)

= –$1,444.54

The IRR is 11.81%. To confirm this on your calculator, set PV = ()20,000; PMT = 4000;
FV = 0; n = 8, and compute i. The project will be rejected for any discount rate above this
rate.

21. a. The present value of the savings is 100/r

If r = .08, PV = 1,250 and NPV = –1,000 + 1,250 = $250

If r = .10, PV = 1,000 and NPV = –1,000 + 1,000 = $0

b. IRR = .10 or 10%. At this discount rate, NPV = $0.

c. Payback = 10 years.

d. Discounted Payback

Cash Flow Discounted Cash Flow Cumulative Discounted

Year
($) ($) @ 8 percent Cash Flow ($)
0 -1000 -1000 -1000
1 100 92.6 -907.4
2 100 85.7 -821.7
3 100 79.4 -742.3
4 100 73.5 -668.8
5 100 68.1 -600.7
6 100 63.0 -537.7
7 100 58.3 -479.4
8 100 54.0 -425.4

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 9 100 50.0 -375.4
10 100 46.3 -329.1
11 100 42.9 -286.2
12 100 39.7 -246.5
13 100 36.8 -209.7
14 100 34.0 -175.7
15 100 31.5 -144.2
16 100 29.2 -115.0
17 100 27.0 -88.0
18 100 25.0 -63.0
19 100 23.2 -39.8
20 100 21.5 -18.3
21 100 19.9 1.6

Discounted payback when cost of capital is 8 percent = 20 years +18.3/19.9 =

20.95 years.

The NPV=0 when the cost of capital =10%. The savings are supposed to last
forever. Therefore, there is no finite discounted payback period when cost of
capital is 10%.

25. a. Project A
Cash Flow Discounted Cash Flow Cumulative Discounted
Year
($) ($) @ 10 percent Cash Flow ($)
0 -5000 -5000.00 -5000.00
1 1000 909.09 -4090.91
2 1000 826.45 -3264.46
3 3000 2253.94 -1010.52
4 0.00 0.00 -1010.52
NPV= -1010.52

The payback period for Project A is 3 years.

Project A does not pay back on a discounted basis since cumulative discounted
cash flows remain negative until the end of Year 4.

Project B
Cash Flow Discounted Cash Flow Cumulative Discounted
Year
($) ($) @ 10 percent Cash Flow ($)
0 -1000 -1000.00 -1000
1 0 0 -1000
2 1000 826.45 -173.55
3 2000 1502.63 1329.08
4 3000 2049.04 3378.12
NPV= 3378.12

The payback period for Project B is 2 years.

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 The discounted payback period for Project B is 2 years + 173.55/1502.63 =
2.12 years.

Project C
Cash Flow Discounted Cash Flow Cumulative Discounted
Year
($) ($) @ 10 percent Cash Flow ($)
0 -5000 -5000.00 -5000.00
1 1000 909.09 -4090.91
2 1000 826.45 -3264.46
3 3000 2253.94 -1010.52
4 5000 3415.07 2404.55
NPV= 2404.55

The payback period for Project C is 3 years.

The discounted payback period for Project C is 3 years + 1010.52/3415.07 =

3.3 years.

b. Only B satisfies the 2-year payback criterion.

c. You would accept Project B

d. Projects B and C

Project NPV
A -1010.52
B 3378.12
C 2404.55

e. False. Payback gives no weight to cash flows after the cutoff date.

29. a. The present values of the project cash flows (net of the initial investments) are:

NPVA = –2100 + + = $400

NPVB = –2100 + + = $300

The initial investment for each project is 2100.

Profitability index (A) = 400/2100 = 0.1905

Profitability index (B) = 300/2100 = 0.1429

b. If you can choose only one project, choose A for its higher profitability index.
If you can take both projects, you should: Both have positive profitability
index.

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30. a. The less–risky projects should have lower discount rates.

b. First, find the profitability index of each project.

PV of Profitability
Project Cash flow Investment NPV Index
A 3.79 3 0.79 0.26
B 4.97 4 0.97 0.24
C 6.62 5 1.62 0.32
D 3.87 3 0.87 0.29
E 4.11 3 1.11 0.37

Then select projects with the highest profitability index until the $8 million budget is
exhausted. Choose, therefore, projects E and C.

c. All the projects have positive NPV. All will be chosen if there is no rationing.

33. a. Assuming an opportunity cost of capital of 6%

(i) Payback Period

Payback
Cash Flows, Dollars
Project Period,
C0 C1 C2 C3 C4 C5 years
I -250000 12000 18000 18000 30000 250000 5.69
II -25000 15000 8000 6000 6000 500 3.33

Project II provides the lowest payback period, and thus is the project of choice
under this decision criterion.

(ii) Discounted Payback Period

Project I
Discounted Cash Flow Cumulative Discounted
Year Cash Flow ($)
($) @ 6 percent Cash Flow ($)
0 -250000.00 -250000.00 -250000.00
1 12000.00 11320.75 -238679.25
2 18000.00 16019.94 -222659.31
3 18000.00 15113.15 -207546.16
4 30000.00 23762.81 -183783.35
5 250000.00 186814.54 3031.19
NPV= 3031.19

Discounted payback period is 4 years + 183783.35/186814.54 = 4.98 years.

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 Project II
Discounted Cash Flow Cumulative Discounted
Year Cash Flow ($)
($) @ 6 percent Cash Flow ($)
0 -25000.00 -25000.00 -25000.00
1 15000.00 14150.94 -10849.06
2 8000.00 7119.97 -3729.09
3 6000.00 5037.72 1308.63
4 6000.00 4752.56 6061.19
5 500.00 373.63 6434.82
NPV= 6434.82

Discounted payback period is 2 years + 3729.09/5037.72 = 2.74 years.

Project II has the lower discounted payback period at 2.74 years, and thus it is
the best choice under this decision criterion.

(iii) NPV at 6% for: Project I = $3031.19

Project II = $6434.82

Since Project II offers a higher NPV, it is the best choice under this decision
criterion.

(iv) IRRI = 6.29%

IRRII = 19.04%

Project II has the higher IRR and is, therefore, the better choice.

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 NPV
(v) Profitability Index (PI) =
Initial Investment i

3,031.19
PI Project I =  0.012
250,000

6,434.82
PI Project II =  0.26
25,000

Project II offers the highest ratio of net present value to investment; therefore,
we would choose Project II.

b. Of the two projects, Project II is the better choice. It has lower payback and
discounted payback periods. In addition, Project II has the higher NPV, IRR
and profitability index.

36. a. The following table shows the NPV profile of the project. NPV is zero at an
interest rate between 7% and 8% and at an interest rate between 33% and
34%. These are the two IRRs of the project. You can use your calculator to
confirm that the two IRR’s are, more precisely, 7.16% and 33.67%.

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 Discount rate NPV Discount rate NPV
0.00 –2.00 0.21 0.82
0.01 –1.62 0.22 0.79
0.02 –1.28 0.23 0.75
0.03 –0.97 0.24 0.71
0.04 –0.69 0.25 0.66
0.05 –0.44 0.26 0.60
0.06 –0.22 0.27 0.54
0.07 –0.03 0.28 0.47
0.08 0.14 0.29 0.39
0.09 0.29 0.30 0.32
0.10 0.42 0.31 0.24
0.11 0.53 0.32 0.15
0.12 0.62 0.33 0.06
0.13 0.69 0.34 –0.03
0.14 0.75 0.35 –0.13
0.15 0.79 0.36 –0.22
0.16 0.83 0.37 –0.32
0.17 0.85 0.38 –0.42
0.18 0.85 0.39 –0.53
0.19 0.85 0.40 –0.63
0.20 0.84 0.41 –0.74

b. At 5% the NPV is:

NPV = –22 + + + – = –0.443

Since the NPV is negative the project is not attractive.

c. At 20% the NPV is:

NPV = –22 + + + – = 0.840

At 40% the NPV is:

NPV = –22 + + + – = –0.634

d. At a low discount rate, the positive cash flows ($20 for 3 years) are not
discounted much. However, the final negative cash flow of $40 does not get
discounted very heavily either. The net effect is a negative NPV.

At very high rates, the positive cash flows are discounted very heavily,
resulting in a negative NPV. For mid-range discount rates, the positive cash
flows that occur in the middle of the project dominate and project NPV is
positive.

46.

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 (a) Payback period:
Project A A’s Cumulative Project B B’s cumulative
Year cash flow cash flow cash flow cash flow
0 - 10,000 -10,000 -15,000 -15,000
1 6,000 -4,000 3,000 -12,000
2 6,000 2,000 5,000 -7,000
3 6,000 8,000 7,000 0
4 6,000 14,000 8,000 8,000

Payback for Project A = 1 + 4,000/6,000

= 1.667 years
Payback for Project B = 3 years

According to this method, Project A is preferred since it pays back earlier than
Project B.

While the payback method is relatively easy to use, its major disadvantages are: (i) It does
not take into consideration the time value of money and (ii) it ignores cash flows beyond
the payback period.

Discounted Payback and NPV:

Discount A’s discounted A’s Cumulative B’s discounted B’s cumulative

Year Factor 10 % cash flow Discount cash cash flow Discount cash
flow flow
0 1.000 -10,000 -10,000 -15,000 -15,000
1 .909 5,454 -4,546 2,727 -12,273
2 .826 4,956 410 4,130 -8,143
3 .751 4,506 4,916 5,257 -2,886
4 .683 4,098 9,014 5,464 2,578
NPV 9,014 2,578

Based on NPV project A is preferred.

Discounted payback for Project A = 1 + (4,546/4,956) = 1.92 years

Discounted payback for Project B = 3 + (2,886/5464) = 3.53 years

Once again, according to the discounted payback method, Project A is preferred

since it pays back earlier than Project B.

The main advantage of the discounted payback period is that this method considers
the time value of money, unlike the payback period.

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 The main flaw of the discounted payback period is that it does not consider cash
flows beyond the payback period and therefore, it may on occasion incorrectly reject
positive NPV projects.

(b). We see from the computations above that the NPV for Project A is $9,014
whereas for Project B it is $2,578. In general, notice also that if projects are able
meet the cutoff in terms of a discounted payback, they must have a positive NPV.

Based on the NPV approach, Project A is preferred to Project B as it has the higher
NPV.

(c). The profitability index for Project A = $9,014/$10,000 = .9014

For Project B, it is $2,578/$15,000 = .172.

Once again, Project A is preferable using this method.

(d). Internal Rate of return-

Trial and Error Approach.: Essentially, with this approach we try to select the
discount rate at which the IRR for the project =0. This discount rate is, then,
also the project’s IRR.

Project A
Let us try a discount rate of 48 %. At this rate,
NPV = -10,000 + {6,000/ (1+.48)1} + {6,000/ (1+.48)2} + {6,000/ (1+.48)3}
+ {6,000/ (1+.48)4}
NPV = - 105.28

Since NPV is negative at this rate, the IRR should be lower than 48 percent.

Let us try a discount rate of 46 %. At this rate,

NPV = -10,000 + {6,000/ (1+.46)1} + {6,000/ (1+.46)2} + {6,000/
(1+.46)3} + {6,000/ (1+.46)4}
NPV = 172.82

So, we can assume that the IRR for project A is somewhere between 46% and
48 %.

Notice that this 2 % difference between the two rates has an “NPV distance” of
278.1 (i.e. 105.28 + 172.82).

So, by interpolation, NPV will be 0 at a rate which is (2/278.1 x 105.28) below

48%; or 0.76% below 48% = 47.24%

It is actually 47.23 % (using a financial calculator).

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 Project B
Let us try an initial discount rate of 17 %. At this rate,
NPV = -15,000 + {3,000/ (1+.17)1} + {5,000/ (1+.17)2} + {7,000/ (1+.17)3}
+ {8,000/ (1+.17)4}
NPV = - 143.54

Since NPV is negative at 17%, the IRR should be lower than this rate.

Let us try a discount rate of 15 %. At this rate,

NPV = - 15,000 + {3,000/ (1+.15)1} + {5,000/ (1+.15)2} + {7,000/ (1+.15)3}
+ {8,000/ (1+.15)4}
NPV = 566.04

So, we know that the IRR for project B is some where between 15 % and 17
%.
Once again, notice that this 2 % difference between the two rates has an “NPV
distance” of 709.58 (i.e. 143.54 + 566.04).

So, by interpolation, NPV will be 0 at a rate which is (2/709.58 x 143.54) below

17%; or 0.4% below 17% = 16.6%

It is actually 16.58 % (using a financial calculator).

Notice that, for both Projects A and B, we were able to get results for the IRR
that were quite close to the actual numbers obtained through a financial
calculator.

Using the IRR rule, Project A (with the higher IRR) is preferred over Project B.

e)   Independent projects would be evaluated for acceptance or rejection on a 
“standalone” basis. Mutually exclusive projects would be selected on an 
“either/or” basis and only those contributing most toward shareholder wealth 
would be selected.

f)   In this question we are able to reach the same decision using all the methods  
(payback, discounted payback, NPV, profitability index, and IRR) However, if 
we  get conflicting decisions using different methods then the NPV method 
should be used as it is generally considered to be the most robust.

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