Chapter 05 - Net Present Value and Other Investment Criteria

CHAPTER 5
Net Present Value and Other Investment Criteria

The values shown in the solutions may be rounded for display purposes. However, the answers were
derived using a spreadsheet without any intermediate rounding.

Answers to Problem Sets

1. a. A = 3 years; B = 2 years; C = 3 years

b. B

c. A, B, and C

d. B and C (At 10%, NPVA = –$1,011; NPVB = $3,378; NPVC = $2,405)

e. True. The payback rule ignores all cash flows after the cutoff date, meaning that future
years’ cash inflows are not considered. Thus, payback is biased towards short-term
projects.

f. It will accept no negative-NPV projects, but will turn down some with
positive NPVs. A project can have a positive NPV if all future cash flows
are considered but still not meet the stated cutoff period.

Est. time: 6 – 10

2. a. NPVA = –$1,000 + $1,000 / (1 + .10) = –$90.91

NPVB = –$2,000 + $1,000 / (1 + .10) + $1,000 / (1 + .10)2 + $4,000 / (1 + .10)3 +

$1,000 / (1 + .10)4 + $1,000 / (1 + .10)5
NPVB = $4,044.73

NPVC = –$3,000 + $1,000 / (1 + .10) + $1,000 / (1 + .10)2 + $1,000 / (1 + .10)4

+ $1,000 / (1 + .10)5
NPVC = $39.47

Projects B and C have positive NPVs.

b. Payback A = 1 year
Payback B = 2 years
Payback C = 4 years

c. Accept projects A and B

d. Project A:
PV = CFt / (1 + r)t

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Chapter 05 - Net Present Value and Other Investment Criteria

PVA = $1,000 / (1 + .10)

PVA = $909.09
The present value of the cash inflows for Project A is less than the initial outlay for the
project, which means the project never pays back on a discounted basis. This is true for
any negative NPV project.

Project B:
The present values of the cash inflows for Project B are shown in the second row of the
table below, and the cumulative net present values are shown in the last row.
C0 C1 C2 C3 C4 C5
–$2,000 $1,000.00 $1,000.00 $4,000.00 $1,000.00 $1,000.00
–2,000 909.09 826.45 3,005.26 683.01 620.92
–1,090.91 –264.46 2,740.80 3,423.81 4,044.73

Since the cumulative NPV turns positive between year 2 and year 3, the discounted
payback period is calculated as:
Discounted payback period = 2 + $264.46 / $3,005.26 = 2.09 years

Project C:
The present values of the cash inflows for Project C are shown in the second row of the
table below, and the cumulative net present values are shown in the last row.

C0 C1 C2 C3 C4 C5
–$3,000 $1,000.00 $1,000.00 $ 0.00 $1,000.00 $1,000.00
–3,000 909.09 826.45 0.00 683.01 620.92
–2,090.91 –1,264.46 –1,264.46 –581.45 39.47

Since the cumulative NPV turns positive between year 4 and year 5, the discounted
payback period is:

Discounted payback period = 4 + $581.45 / $620.92 = 4.94 years

e. Using the discounted payback period rule with a cutoff of three years, the firm would
accept only Project B.

Est. time: 11– 15

3. a. When using the IRR rule, the firm must still compare the IRR with the opportunity cost of
capital. Thus, even with the IRR method, one must specify the appropriate discount rate.

b. Risky cash flows should be discounted at a higher rate than the rate used to discount
less risky cash flows. Using the payback rule is equivalent to using the NPV rule with a
zero discount rate for cash flows before the payback period and an infinite discount rate
for cash flows thereafter.
Est. time: 1 – 5

4. Given the cash flows C0, C1, . . . , CT, IRR is defined by:

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Chapter 05 - Net Present Value and Other Investment Criteria

NPV = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + … + CT / (1 + IRR)T = 0

IRR is calculated by trial and error, by financial calculators, or by spreadsheet

programs.

Est. time: 1 – 5

5. a. NPV = –$6,750 + $4,500 / (1 + 0) + $4,500 / (1 + 0)2 = $15,750

NPV = –$6,750 + $4,500 / (1 + .50) + $4,500 / (1 + .50)2 = $4,250
NPV = –$6,750 + $4,500 / (1 + 1) + $4,500 / (1 + 1)2 = $0

b. 100%; NPV = 0 when the discount rate is 100 percent.

Est. time: 1 – 5

6.
r = -17.44% 0.00% 10.00% 15.00% 20.00% 25.00% 45.27%
Year 0 –3,000.00 –3,000.00 –3,000.00 –3,000.00 –3,000.00 –3,000.00 –3,000.00 –3,000.00
Year 1 3,500.00 4,239.34 3,500.00 3,181.82 3,043.48 2,916.67 2,800.00 2,409.31
Year 2 4,000.00 5,868.41 4,000.00 3,305.79 3,024.57 2,777.78 2,560.00 1,895.43
Year 3 –4,000.00 -7,108.06 -4,000.00 -3,005.26 -2,630.06 -2,314.81 -2,048.00 -1,304.76
PV = -.31 500.00 482.35 437.99 379.64 312.00 -.02
The two IRRs for this project are (approximately): –17.44% and 45.27%.
Between these two discount rates, the NPV is positive.

Est. time: 06 - 10

7. No; you would not accept this offer as you are effectively “borrowing” at a rate of interest higher
than the opportunity cost of capital. You can verify this decision by proving that the NPV is
negative as follows:

NPV = –$5,000 + $4,000 / (1 + .10) + (–$11,000) / (1 + .10)2

NPV = –$10,455

Est. time: 1 – 5

8 a. Two; because the cash flows change direction twice.

b. −50% and +50%. The NPV for the project using both of these IRRs is 0.

c. Yes, the NPV is positive at 20 percent

NPV = –$100 + $200 / (1 + .20) + (–$75) / (1 + .20)2

NPV = $14.58

Est. time: 1 – 5

9. NPV = 0 = [–$400,000 – (–$200,000)] + ($241,000 – 131,000) / (1 + IRR) +

($293,000 – 172,000) / (1 + IRR)2

Incremental IRR = 10%

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Chapter 05 - Net Present Value and Other Investment Criteria

The IRR on Project Beta exceeds the cost of capital. So, since the IRR on the incremental
investment in Project Alpha also exceeds the cost of capital, choose Alpha.

Est. time: 1 – 5

10. a. The figure shown below was drawn from the following points:
Discount Rate
0% 10% 20%
NPVA +20.00 +4.13 -8.33
NPVB +40.00 +5.18 -18.98

b. From the graph, we can estimate the IRR of each project from the point where its line
crosses the horizontal axis:
IRRA = 13.1% and IRRB = 11.9%

This can be checked by calculating the NPV for each project at their respective IRRs,
which give an approximate NPV of 0.

c. The company should accept Project A if its NPV is positive and higher than that of Project
B; that is, the company should accept Project A if the discount rate is greater than 10.7%
(the intersection of NPVA and NPVB on the graph below) and less than 13.1% (the
internal rate of return).

d. The cash flows for (B – A) are:

C0 = $ 0
C1 = –$60
C2 = –$60
C3 = +$140
Therefore:
Discount Rate
0% 10% 20%
NPVB − A +20.00 +1.05 -10.65

IRRB − A = 10.7%
The company should accept Project A if the discount rate is greater than 10.7% and less
than 13.1%. As shown in the graph, for these discount rates, the IRR for the incremental
investment is less than the opportunity cost of capital.

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Chapter 05 - Net Present Value and Other Investment Criteria

50.00
40.00
30.00
20.00 Project A
NPV

10.00 Project B
Increment
0.00
-10.00
-20.00
-30.00
0% 10% 20%
Rate of Interest

Est. time: 06 - 10

11. a. Because Project A requires a larger capital outlay, it is possible that Project A has both a
lower IRR and a higher NPV than Project B. (In fact, NPVA is greater than NPVB for all
discount rates less than 10%.) Because the goal is to maximize shareholder wealth,
NPV is the correct criterion.

b. To use the IRR criterion for mutually exclusive projects, calculate the IRR for the
incremental cash flows:
C0 C1 C2 IRR
A-B −200 +110 +121 10%

Because the IRR for the incremental cash flows exceeds the cost of capital, the
additional investment in A is worthwhile.

c. NPVA = –$400 + $250 / 1.09 + $300 / 1.092

NPVA = $81.86

NPVB = –$200 + $140 / 1.09 + $179 / 1.092

NPVB = $79.10

Est. time: 06 - 10

12. NPV = 0 = [–$550,000 – (–$250,000)] / (1 + IRR)1 + [$650,000 – (–$250,000)] / (1 + IRR)2

+ ($0 – $650,000) / (1 + IRR)3

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Chapter 05 - Net Present Value and Other Investment Criteria

NPV = 0 = –$300,000 / (1 + IRR) + $900,000 / (1 + IRR)2 + (–$650,000) / (1 + IRR)3

Because the cash flows change direction twice, there are two IRRs. The IRRs for the incremental
flows are approximately 21.13 percent and 78.87 percent. If the cost of capital is between these
two rates, Titanic should work the extra shift.

Est. time: 06 - 10

13. The following table and plot outline each project’s sensitivity to the discount rate:
Net Present Value: Sensitivity Analysis
Discount Rate Project A Project B Project C Project D
0% 20 (10) (30) (70)
3% 14 (3) (24) (57)
6% 8 2 (18) (47)
9% 3 4 (13) (40)
12% (2) 5 (8) (35)
15% (7) 5 (4) (32)
18% (11) 3 0 (30)
21% (15) 0 4 (30)
24% (19) (3) 8 (31)
27% (22) (8) 11 (34)
30% (25) (13) 14 (37)

Net Present Value: Sensitivity to Discount Rate

40

20
Project C
-
Net Present Value

Project B
(20)
Project A
(40) Project D

(60)

(80)
0% 3% 6% 9% 12% 15% 18% 21% 24% 27% 30%

a. Discount
From the plots or the table, we Rate that project D has no IRR. There is no discount
can see
rate at which the net present value is zero

b. Project B will have two IRR’s, because it crosses zero NPV twice. Once at around 5%
and again at around 21%

c. Project A has an IRR of 10% and Project C has an IRR of 18%.

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Chapter 05 - Net Present Value and Other Investment Criteria

d. Project C is a cash inflow followed by cash outflows (i.e. a loan), so it is favorable to have
an IRR that is lower than the cost of capital. Therefore, all else equal, it is more likely to
accept the project the higher the cost of capital for this type of cash flow pattern.

Est. time: 1 – 5

14. The following table and plot outline each project’s sensitivity to the discount rate:

Project C0 C1 C2 C3 C4 IRR
A $ (200) $ 80 $ 80 $ 80 $ 80 22%
B (200) 100 100 100 - 23%

Net Present Value: Sensitivity Analysis

Discount Rate Project A Project B
10% 54 49
11% 48 44
12% 43 40
13% 38 36
14% 33 32
15% 28 28
16% 24 25
17% 19 21
18% 15 17
19% 11 14
20% 7 11

Net Present Value: Sensitivity to Discount Rate

60

50

40
Net Present Value

30

20

10 Project B
Project A
-
10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
Discount Rate
a. At an 11% discount rate, both projects are acceptable with positive NPV.

b. If mutually exclusive, project A yields a higher NPV than project B

c. At a 16% discount rate, Project B is more favorable than Project A.

d. Project A is fully paid back by year 3.

Project B is fully paid back by year 2.

e. The project with the highest NPV depends on the discount rate.

f. Project A has an IRR of 22%.

Project B has an IRR of 23%.

g. The project with the highest NPV depends on the discount rate.

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Chapter 05 - Net Present Value and Other Investment Criteria

h. Profitability Index = NPV/investment

Profitability IndexA = $48/$200 = 0.24

Profitability IndexB = $44/$200 = 0.22

In this case, since the investment amounts are the same, both NPV and profitability index
indicate the same answer: pick project A at an 11% discount rate. If capital is rationed,
then profitability index is preferable and used to accept projects with the highest index
descending until the capital ration is exhausted. Without capital rationing, accept all
projects with a positive NPV.
Est. time: 1 – 5

15. a. NPVD = –$10,000 + $20,000 / (1 +.10)

NPVD = $8,181.82

NPVE = –$20,000 + $35,000 / (1 + .10)

NPVE = $11,818.18

PI = NPV / investment
PID = $8,181.82 / $10,000
PID = .82

PIE = $11,818.18 / $20,000

PIE = .59

Each project has a positive PI, thus, both projects are acceptable.

b. In order to choose between these projects, we must use incremental analysis. For the
incremental cash flows:

NPVE – D = [–$20,000 – (–$10,000)] + ($35,000 – 20,000) / (1 + .10)

NPVE – D= $3,636.36

PIE – D = $3,636.36 / ABS[–$20,000 – (–$10,000)]

PIE – D = .36

The incremental PI is positive so the larger project should be accepted, i.e., accept
Project E. Note that, in this case, the project that was accepted has the lower PI.

Est. time: 11 - 15

16. 1, 2, 4, and 6

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Chapter 05 - Net Present Value and Other Investment Criteria

The profitability index for each project is shown below:

Project NPV Investment Profitability Index (NPV/Investment)

5,0 10,0
1 00 00 5,000 / 10,000 = .5
5,0 5,
2 00 000 5,000 / 5,000 = 1
10,0 90,0
3 00 00 10,000 / 90,000 = .11
15,0 60,0
4 00 00 15,000 / 60,000 = .25
15,0 75,0
5 00 00 15,000 / 75,000 = .2
3,0 15,0
6 00 00 3,000 / 15,000 = .2

Start with the project with the highest profitability index and go from there. Project 2 has the highest
profitability index and has an initial investment of $5,000. The next highest profitability index is for
Project 1, which has an initial investment of $10,000. The next highest is Project 4, which will cost
$60,000 up front. So far we have spent $75,000. Projects 5 and 6 both have profitability indexes
of .2, but we only have $15,000 left to spend, so we will add Project 6 to our list. This gives us
Projects 1, 2, 4, and 6.

Est. time: 1 – 5

17. Using the fact that profitability index = (net present value / investment), we find:
Project Profitability Index
1 .22
2 −.02
3 .17
4 .14
5 .07
6 .18
7 .12
Thus, given the budget of $1 million, the best the company can do is to accept Projects 1, 3, 4,
and 6.
If the company accepted all positive NPV projects, the market value (compared to the market
value under the budget limitation) would increase by the NPV of Project 5 plus the NPV of Project
7: $7,000 + $48,000 = $55,000. Thus, the budget limit costs the company $55,000 in terms of its
market value.

Est. time: 06 - 10

18. The IRR is the discount rate which, when applied to a project’s cash flows, yields NPV = 0. Thus,
it does not represent an opportunity cost. However, if each project’s cash flows could be invested
at that project’s IRR, then the NPV of each project would be zero because the IRR would then be
the opportunity cost of capital for each project. The discount rate used in an NPV calculation is
the opportunity cost of capital. Therefore, it is true that the NPV rule does assume that cash
flows are reinvested at the opportunity cost of capital.

Est. time: 06 - 10

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Chapter 05 - Net Present Value and Other Investment Criteria

19.
a.
C0 = –3,000 C0 = –3,000
C1 = 3,500 C1 = 3,500
C2 = 4,000 C2 + PV(C3) = 4,000 – 3,571.43 = 428.57
C3 = –4,000 MIRR = 27.84%

xC2 C3
xC1 + =−
b. 1. 12 1 .12 2
(1.122)(xC1) + (1.12)(xC2) = –C3
(x)[(1.122)(C1) + (1.12C2)] = –C3
X = –C3 / [(1.122)(C1) + (1.12)(C2)
X = 4,000 / [(1.122)(3,500) + (1.12)(4,000)]
X = .45

C0 + (1 – x)C1 / (1 + IRR) + (1 – x)C2 / (1 + IRR)2 = 0

–3,000 + (1 – .45)(3,500) / (1 + IRR) + (1 – .45)(4,000) / (1 + IRR)2 = 0

Now, find MIRR using either trial and error or the IRR function (on a financial calculator or
Excel). We find that MIRR = 23.53%.
It is not clear that either of these modified IRRs is at all meaningful. Rather, these
calculations seem to highlight the fact that MIRR really has no economic meaning.

Est. time: 11 - 15

20. Maximize: NPV = 6,700xW + 9,000xX + 0xY – 1,500xZ

subject to: 10,000xW + 0xX + 10,000xY + 15,000xZ  20,000
10,000xW + 20,000xX – 5,000xY – 5,000xZ  20,000
0xW - 5,000xX – 5,000xY – 4,000xZ  20,000
0  xW  1
0  xX  1
0  xY  1
0  xZ  1
Using Excel Spreadsheet Add-in Linear Programming Module:
Optimized NPV = $13,500
with xW = 0; xX = 1.5; xY = 2 and xZ = 0
If financing available at t = 0 is $21,000:
Optimized NPV = $13,725
with xW = 0; xX = 1.53; xY = 2.1 and xZ = 0

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Chapter 05 - Net Present Value and Other Investment Criteria

Here, the shadow price of an additional $1,000 invested at t =0 is $225.

In both cases, the program viewed xY as a viable choice, even though the NPV of Project Y is
zero. The reason for this result is that Project Y provides a positive cash flow in periods 1 and 2.
If the financing available at t = 1 is $21,000:
Optimized NPV = $13,950
with xW = 0; xX = 1.55; xY = 2 and xZ = 0
Hence, the shadow price of an additional $1,000 in t =1 financing is $450.

Est. time: 11 - 15

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