Chapter 9 PDF

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Chapter 9 Questions and Problems Basic (Questions 1–19) 1. Calculating Payback (LO2) What is the payback period for the following set of cash flows?

2. Calculating Payback (LO2) An investment project provides cash inflows of $765 per year for eight years. What is the project payback period if the initial cost is $2,400? What if the initial cost is $3,600? What if it is $6,500? 3. Calculating Payback (LO2) McKernan Inc. imposes a payback cutoff of three years for its international investment projects. If the company has the following two projects available, should they accept either of them?

5. Calculating Discounted Payback (LO3) An investment project costs $15,000 and has annual cash flows of $4,300 for six years. What is the discounted payback period if the discount rate is zero percent? What if the discount rate is 5 percent? If it is 19 percent? 6. Calculating AAR (LO4) You're trying to determine whether to expand your business by building a new manufacturing plant. The plant has an installation cost of $15 million, which will be depreciated straight-line to zero over its four-year life. If the plant has projected net income of $1,938,200, $2,201,600, $1,876,000 and $1,329,500 over these four years, what is the project's average accounting return (AAR)? 7. Calculating IRR (LO5) A firm evaluates all of its projects by applying the IRR rule. If the required return is 16 percent, should the firm accept the following project?

8. Calculating NPV (LO1) For the cash flows in the previous problem, suppose the firm uses the NPV decision rule. At a required return of 12 percent, should the firm accept this project? What if the required return was 35 percent? 9. Calculating NPV and IRR (LO1, 5) A project that provides annual cash flows of $28,500 for nine years costs $138,000 today. Is this a good project if the required return is 8 percent? What if it's 20 percent? At what discount rate would you be indifferent between accepting the project and rejecting it? 10. Calculating IRR (LO5) What is the IRR of the following set of cash flows?

11. Calculating NPV(LO1) For the cash flows in the previous problem, what is the NPV at a discount rate of zero percent? What if the discount rate is 10 percent? If it is 20 percent? If it is 30 percent? 12. NPV versus IRR (LO1, 5) Parkallen Inc. has identified the following two mutually exclusive projects:

a) What is the IRR for each of these projects? Using the IRR decision rule, which project should the company accept? Is this decision necessarily correct? b) If the required return is 11 percent, what is the NPV for each of these projects? Which project will the company choose if it applies the NPV decision rule? c) Over what range of discount rates would the company choose Project A? Project B? At what discount rate would the company be indifferent between these two projects? Explain.

13. NPV versus IRR (LO1, 5) Consider the following two mutually exclusive projects:

Sketch the NPV profiles for X and Y over a range of discount rates from zero to 25 percent. What is the crossover rate for these two projects? 14. Problems with IRR (LO5) Belgravia Petroleum Inc. is trying to evaluate a generation project with the following cash flows:

a) If the company requires a 12 percent return on its investments, should it accept this project? Why? b) Compute the IRR for this project. How many IRRs are there? Using the IRR decision rule, should the company accept the project? What's going on here? 16. Problems with Profitability Index (LO1, 7) The Hazeldean Computer Corporation is trying to choose between the following two mutually exclusive design projects:

a) If the required return is 10 percent and the company 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 your answers in (a) and (b) are different.

17. Comparing Investment Criteria (LO1, 2, 3, 5, 7) Consider the following two mutually exclusive projects:

Whichever project you choose, if any, you require a 15 percent return on your investment. a) If you apply the payback criterion, which investment will you choose? Why? b) If you apply the discounted payback criterion, which investment will you choose? Why? c) If you apply the NPV criterion, which investment will you choose? Why? d) If you apply the IRR criterion, which investment will you choose? Why? e) If you apply the profitability index criterion, which investment will you choose? Why? f) Based on your answers in (a) through (e), which project will you finally choose? Why? Intermediate (Questions 20–22) 20. NPV and the Profitability Index (LO6) If we define the NPV index as the ratio of NPV to cost, what is the relationship between this index and the profitability index? Challenge (Questions 23–28) 23. Payback and NPV (LO2, 5) An investment under consideration has a payback of seven years and a cost of $724,000. If the required return is 12 percent, what is the worst-case NPV? The best-case NPV? Explain. Assume the cash flows are conventional. 24. Multiple IRRs (LO5) This problem is useful for testing the ability of financial calculators and computer software. Consider the following cash flows. How many different IRRs are there (Hint: search between 20 percent and 70 percent)? When should we take this project?

25. NPV Valuation (LO1) The Argyll Corporation wants to set up a private cemetery business. According to the CFO, Kepler Wessels, business is “looking up.” As a result, the cemetery project will provide a net cash inflow of $85,000 for the firm during the first year, and the cash flows are projected to grow at a rate of 6 percent per year forever. The project requires an initial investment of $1,400,000. 1. If Argyll requires a 13 percent return on such undertakings, should the cemetery business be started? 2. The company is somewhat unsure about the assumption of a 6 percent growth rate in its cash flows. At what constant growth rate would the company just break even if it still required a 13 percent return on investment? 26. Problems with IRR (LO1, 5) A project has the following cash flows:

What is the IRR for this project? If the required return is 12 percent, should the firm accept the project? What is the NPV of this project? What is the NPV of the project if the required return is 0 percent? 24 percent? What is going on here? Sketch the NPV profile to help you with your answer.

Solution



1 2 3

3.43 years 3.14 years 1.84 years

4.71 years 3.02 years

8.49 years accept project A and reject project B

5 6 7 8 9 10 11 12

3.49 years

3.93 years

The project never pays back

24.48% 20.97% 5311.91 (accept)

–$6174.97 (reject)

13 14

$40,036.31 22.64% $9,200

accept;

–$23,117.45

reject

14.59%

$4,382.79 $796.30 –$ 1,952.44 20.44% 18.84% $7,507.61 $9,182.29 At discount rates above 15.3% choose project A; for discount rates below 15.3% choose project B; indifferent between A and B at a discount rate of 15.3%. 



14 16

17

20

11.73% a) $13,482,142.86

b)53%and‐69.67% b 1.414



a) 1.267 $14,145 $6,630.35 Using the profitability index to compare mutually exclusive projects can be ambiguous when the magnitude of the cash flows for the two projects are of different scale. In 3.46 years

2.5 years $11,058.07 $3,434.16 1.037 1.086 NPV index = PI – 1

3.95 years 16.20%

3.43 years 19.50%

23 24 25 26 

–$396,499.17 25%, 33.33%, 42.86%, and 66.67% 6.93% –$185,714.29  22.14% –$8,230.87 –$21,000.00 $1,314.26...