Selected Solution to Chapter 9 : Net present value and other investment criteria

Q13

NPV versus IRR Consider the following two mutually exclusive projects:
Year
0
1
2
3

Cash Flow (X)

-4,000
2,500
500
1,800

Cash Flow (Y)

-4,000
1,500
2,000
2,600

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?
Period
CF (X)
CF (Y)

0
-$4,000
-$4,000

NPV = cash flow0

NPV (X) =

-$4,000

NPV (Y) =

-$4,000

1
2,500
1,500

2
500
2,000

3
1,800
2,600

cash flow1

cash flow2

cash flow3

(1 + r)

(1 + r)

(1 + r)3

2,500

500
(1 + r)2

1,800
(1 + r)3

2,000
(1 + r)2

2,600
(1 + r)3

(1 + r)
1,500
(1 + r)

r(%)
NPV (X)
NPV (Y)

0
800
2,100

1%
705
1,950

2%
615
1,807

3%
530
1,671

4%
448
1,541

5%
371
1,418

6%
297
1,300

r(%)
NPV (X)
NPV (Y)

7%
227
1,188

8%
160
1,081

9%
96
979

10%
35
882

11%
-23
789

12%
-79
700

13%
-131
616

r(%)
NPV (X)
NPV (Y)

14%
-182
535

15%
-230
458

16%
-276
384

17%
-320
313

18%
-362
246

19%
-402
181

20%
-440
120

r(%)
NPV (X)
NPV (Y)

21%
-476
61

22%
-511
4

23%
-544
-50

24%
-576
-102

25%
-607
-151

91.73%
-1,202
-1,202

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 21% 22% 23% 24% 25%

2,500
2,000
1,500
1,000
500
0
-500
-1,000

NPV (X)
NPV (Y)

Selected Solution to Chapter 9 : Net present value and other investment criteria
Q17
a. PBA = 3 + ($110K/$380K) = 3.29 years;
PBB = 2 + ($2K/$10K) = 2.20 years
Payback criterion implies accepting project B, because it pays back sooner than project A.
b. A: $10K/1.15 + $25K/1.152 + $25K/1.153 = $44,037.15;
$380K/1.154 = $217,266.23
Discounted payback = 3 + ($170,000 44,037.15)/$217,266.23 = 3.58 years
B: $10K/1.15 + $6K/1.152 = $13,232.51;
$10K/1.153 = $6,575.16
Discounted payback = 2 + ($18,000 13,232.51)/$6,575.16 = 2.73 years
Discounted payback criterion implies accepting project B because it pays back sooner than A
c. A: NPV = $170K + $10K/1.15 + $25K/1.152 + $25K/1.153 + $380K/1.154 = $91,303.38
B: NPV = $18K + $10K/1.15 + $6K/1.152 + $10K/1.153 + $8K/1.154 = $6,381.70
NPV criterion implies accept project A because project A has a higher NPV than project B.
d. A: $170K = $10K/(1+IRR) + $25K/(1+IRR)2 + $25K/(1+IRR)3 + $380K/(1+IRR)4
IRR = 29.34%
B: $18K = $10K/(1+IRR) + $6K/(1+IRR)2 + $10K/(1+IRR)3 + $8K/(1+IRR)4;
IRR = 32.01%
IRR decision rule implies accept project B because IRR for B is greater than IRR for A.
e. A: PI = [$10K/1.15 + $25K/1.152 + $25K/1.153 + $380K/1.154] / $170K = 1.537
B: PI = [$10K/1.15 + $6K/1.152 + $10K/1.153 + $8K/1.154] / $18K = 1.355
Profitability index criterion implies accept project A because its PI is greater than project Bs.
f. In this instance, the NPV and PI criterion imply that you should accept project A, while payback
period, discounted payback and IRR imply that you should accept project B. The final decision
should be based on the NPV since it does not have the ranking problem associated with the other
capital budgeting techniques. Therefore, you should accept project A.

Q23
a. PV of cash inflows = C1/(r g) = $40,000/(.14 .07) = $571,428.57 > 0
NPV of the project = $650,000 + $571,428.57 = $78,571.43 < 0
so don't start the cemetery business.
b. $40,000/(.14 g) = $650,000; g = 7.85%

Selected Solution to Chapter 10 : Making caital investment decisions

Q15

Project Evaluation Your firm is contemplating the purchase of a new $750,000 computer-based
order entry system. The system will be depreciated straight-line to zero over its five-year life. It
will be worth $80,000 at the end of that time. You will save $310,000 before taxes per year in
order processing costs and you will be able to reduce working capital by $125,000 (this is a onetime reduction). If the tax rate is 35 percent, what is the IRR for this project?
Year

(i) Investment
New system
-750,000
Reduced NWC
125,000
Salvage of new system
tax on sale of salvage (35%)
After-tax sale of salvage
Net Investment
-625,000

80,000
28,000
52,000
160,000

(ii) Operation
Saved costs
Depreciation
EBIT
tax (35%)
Net Income
+ plus non-cash expense
Operating Cash Flow

310,000
150,000
160,000
56,000
104,000
150,000
254,000

310,000
150,000
160,000
56,000
104,000
150,000
254,000

310,000
150,000
160,000
56,000
104,000
150,000
254,000

310,000
150,000
160,000
56,000
104,000
150,000
254,000

310,000
150,000
160,000
56,000
104,000
150,000
254,000

(iii) Project CF

254,000

254,000

254,000

254,000

414,000

NPV = 0 =

-625,000

-625,000

254,000

254,000

254,000

254,000

414,000

( 1 + r)

( 1 + r)2

( 1 + r)3

( 1 + r)4

( 1 + r)5

solve for r (or IRR) which makes the above statement valid
IRR or r =

32.8522%

(in Excel type formula "=IRR(values,[guess])

Selected Solution to Chapter 10 : Making caital investment decisions

Q16

Project Evaluation In the previous problem, suppose your required return on the project is 20
percent and your pretax cost savings are only $300,000 per year. Will you accept the project?
What if the pretax cost savings are only $200,000 per year? At what level of pretax cost savings
would you be indifferent between accepting the project and not accepting it?
Year 0
-625,000

(i) Net Investment

(ii) Operation
Saved costs
Depreciation
EBIT
tax (35%)
Net Income
+ plus non-cash expense
Operating Cash Flow

5
160,000

300,000
150,000
150,000
52,500
97,500
150,000
247,500

300,000
150,000
150,000
52,500
97,500
150,000
247,500

300,000
150,000
150,000
52,500
97,500
150,000
247,500

300,000
150,000
150,000
52,500
97,500
150,000
247,500

300,000
150,000
150,000
52,500
97,500
150,000
247,500

(iii) Project CF

247,500

247,500

247,500

247,500

407,500

-625,000

NPV =

-625,000

NPV =

149,564

NPV =

-625,000

247,500
( 1 + 0.2)

247,500
( 1 + 0.2)

247,500
2

( 1 + 0.2)

247,500
3

( 1 + 0.2)

OCF

OCF

OCF

OCF

OCF

160,000

( 1 + 0.2)

( 1 + 0.2)2

( 1 + 0.2)3

( 1 + 0.2)4

( 1 + 0.2)5

( 1 + 0.2)5

+ 160,000 (PVIF5, 20%)

0=

-625,000 + OCF (2.9906)

+ 160,000 (0.4019)

0=

-625,000 + 2.9906(OCF)

+ 64,304

OCF =
OCF =

( 1 + 0.2)5

Accept project because NPV is greater than zero.

-625,000 + OCF (PVIFA5, 20%)

NPV = 0 =

407,500
4

560,696
2.9906
187,486

OCF = Saved cost - depreciation - tax + non cash expense

Saved cost = OCF - non cash + tax + depreciation
=
=

187,486 - 150,000 + 0.35[(187,486 - 150,000)/0.65] + 150,000

207,671 is the level of pretax savings that we'd be indifferent whether to
accept the project

Selected Solution to Chapter 10 : Making caital investment decisions

Q23

Calculating a Bid Price Consider a project to supply 60 million postage stamps per year to the U.S.
Postal Service for the next five years. You have an idle parcel of land available that cost $750,000
five years ago; if the land were sold today, it would net you $900,000. You will need to install $2.4
million in new manufacturing plant and equipment to actually produce the stamps; this plant and
equipment will be depreciated straight-line to zero over the projects five-year life. The
equipment can be sold for $400,000 at the end of the project. You will also need $600,000 in
initial net working capital for the project, and an additional investment of $50,000 in every year
thereafter. Your production costs are 0.6 cents per stamp, and you have fixed costs of $600,000
per year. If your tax rate is 34 percent and your required return on this project is 15 percent, what
bid price should you submit on the contract?

Year 0
(i) Investment
Land
-900,000
new plant
-2,400,000
Salvage of new plang
tax on sale of salvage (34%)
After-tax sale of salvage
NWC
-600,000
Net Investment
-3,900,000
(ii) Operation
Postage stamps sold
Bid price per stamp
Total revenue
variable cost per stamp
Total variable cost
Fixed cost
Depreciation
EBIT
tax (34%)
Net Income
+ plus non-cash expense
Operating cash flow
(iii) Project CF

-3,900,000

900,000

-50,000
-50,000

-50,000
-50,000

-50,000
-50,000

60,000,000
S
60,000,000S
0.6
36,000,000
600,000
480,000

480,000
OCF

60,000,000
S
60,000,000S
0.6
36,000,000
600,000
480,000

480,000
OCF

60,000,000
S
60,000,000S
0.6
36,000,000
600,000
480,000

480,000
OCF

OCF - 50,000

OCF - 50,000

OCF - 50,000

-50,000
-50,000

60,000,000
S
60,000,000S
0.6
36,000,000
600,000
480,000

480,000
OCF

-3,900,000 + OCF (PVIFA5, 15%) - 50,000(PVIFA4, 15%) + 1,964,000(PVIF5, 15%)

0=

-3,900,000 + OCF (3.3522) - 50,000(2.8550) + 1,964,000(0.4972)

0=

-3,900,000 + 3.3522(OCF) - 142,750 + 976,501

OCF =

3,900,000 + 142,750 - 976,501

3.3522

OCF = 914,698
Net Income =
Net Income =
=
EBIT =
=
Total revenue =
=
Min. Bid per stamp =
=

OCF - non cash expense

914,698
- 480000
434,698
Net income / (1- tax rate)
658,633
EBIT + Total cost
658633 + 480,000 + 600,000 + 36,000,000 =
Total revenue / unit sold
0.6289772

37,738,633

400,000
136,000
264,000
800,000
1,964,000

60,000,000
S
60,000,000S
0.6
36,000,000
600,000
480,000

480,000
OCF

OCF - 50,000 OCF + 1,964,000

solve for minimum OCF which makes NPV = 0

NPV = 0 =

Selected Solution to Chapter 11 : Project analysis and Evaluation

Q19

Project Analysis You are considering a new product launch. The project will cost $680,000, have a four-year life, and have no
salvage value; depreciation is straight-line to zero. Sales are projected at 160 units per year; price per unit will be $19,000, variable
cost per unit will be $14,000, and fixed costs will be $150,000 per year. The required return on the project is 15 percent, and the
relevant tax rate is 35 percent.

Base case
Year 0
(i) Investment
project cost
-680,000
(ii) Operation
Unit sold
price per unit
Total revenue
variable cost per unit
Total variable cost
Fixed cost
Depreciation
EBIT
tax (35%)
Net Income
+ plus non-cash expense
Operating cash flow
(iii) Project CF

-680,000

NPV =

-680,000

NPV =

605,303.97

160
19,000
3,040,000
14,000
2,240,000
150,000
170,000
480,000
168,000
312,000
170,000
482,000

160
19,000
3,040,000
14,000
2,240,000
150,000
170,000
480,000
168,000
312,000
170,000
482,000

160
19,000
3,040,000
14,000
2,240,000
150,000
170,000
480,000
168,000
312,000
170,000
482,000

160
19,000
3,040,000
14,000
2,240,000
150,000
170,000
480,000
168,000
312,000
170,000
482,000

482,000

482,000

482,000

482,000

482,000
( 1 + 0.15)

482,000
( 1 + 0.15)2

482,000
( 1 + 0.15)3

482,000
( 1 + 0.15)4

a. Based on your experience, you think the unit sales, variable cost, and fixed cost projections given
here are probably accurate to within 10 percent. What are the upper and lower bounds for these
projections? What is the basecase NPV? What are the best-case and worst-case scenarios?
Normal
Unit sales
Variable cost
Fixed cost

160
14,000
150,000

Upper bound
+ 10%
176
15,400
165,000

Scenario
Unit sales
Variable cost
Fixed cost

Base case
160
14,000
150,000

Worse case
144
15,400
165,000

price per unit

Total revenue
Total variable cost
Fixed cost
Depreciation
EBIT
tax (35%)
Net Income
+ plus non-cash expense
Operating cash flow
Require return
NPV

Base case
19,000
3,040,000
2,240,000
150,000
170,000
480,000
168,000
312,000
170,000
482,000
15.0%
605,304.0

Lower bound
- 10%
144
12,600
135,000
Best case
176
12,600
135,000

Worse case
Best case
19,000
19,000
2,736,000
3,344,000
2,217,600
2,217,600
165,000
135,000
170,000
170,000
183,400
821,400
64,190
287,490
119,210
533,910
170,000
170,000
289,210
703,910
15.0%
15.0%
126,685.5 1,156,215.5

Selected Solution to Chapter 11 : Project analysis and Evaluation

b. Evaluate the sensitivity of your base-case NPV to changes in fixed costs.

Base case
Total revenue
Total variable cost
Fixed cost
Depreciation
EBIT
tax (35%)
Net Income
+ plus non-cash expense
Operating cash flow
Require return
NPV
NPV (%)

3,040,000
2,240,000
150,000
170,000
480,000
168,000
312,000
170,000
482,000
15.0%
605,304.0

Fixed cost
Fixed cost
increase 10% decrease 10%
3,040,000
3,040,000
2,240,000
2,240,000
165,000
135,000
170,000
170,000
465,000
495,000
162,750
173,250
302,250
321,750
170,000
170,000
472,250
491,750
15.0%
15.0%
581,098.7
629,509.2
-4.00%
8.33%

c. What is the cash break-even level of output for this project (ignoring taxes)?
Cash Break even =

=
=
=

Fixed cost
(Price - Variable cost)
150,000
(19,000 - 14,000)
30
570,000

units
sales volume

d. What is the accounting break-even level of output for this project? What is the degree of
operating leverage at the accounting break-even point? How do you interpret this number?
Accounting Break even =

=
=
=
DOL =

Fixed cost + depreciation

(Price - Variable cost)
320,000
(19,000 - 14,000)
64
1,216,000

units
sales volume

1 + (FC / OCF)
1 + (150,000 / 170,000)
1.882
DOL can be intrepreted that 1% change in Q (unit sales) will result in 1.882%
change in OCF.

Selected Solution to Chapter 11 : Project analysis and Evaluation

Q20

Project Analysis McGilla Golf has decided to sell a new line of golf clubs. The clubs will sell for $600 per set and have a variable cost
of $240 per set. The company has spent $150,000 for a marketing study that determined the company will sell 50,000 sets per year
for seven years. The marketing study also determined that the company will lose sales of 12,000 sets of its high-priced clubs. The
high-priced clubs sell at $1,000 and have variable costs of $550. The company will also increase sales of its cheap clubs by 10,000
sets. The cheap clubs sell for $300 and have variable costs of $100 per set. The fixed costs each year will be $7,000,000. The
company has also spent $1,000,000 on research and development for the new clubs. The plant and equipment required will cost
$15,400,000 and will be depreciated on a straight-line basis. The new clubs will also require an increase in net working capital of
$900,000 that will be returned at the end of the project. The tax rate is 40 percent, and the cost of capital is 14 percent. Calculate
the payback period, the NPV, and the IRR.

Year 0
1
2
(i) Investment
Plant & equipmen -15,400,000
* ignored. Because it is sunk cost.
Mkt. study
* ignored. Because it is sunk cost.
R&D
NWC
-600,000
Net Investment
-16,000,000
(ii) Operation
a. Gain from sales of new clubs
price per set
cost per set
marginal gain per set
no. of sets sold
Marginal gain from new clubs

600
240
360
50,000
18,000,000

600,000
600,000

18,000,000

18,000,000

18,000,000

18,000,000

18,000,000

18,000,000

b. Sales gained from incremental cheap club sets

price per set
300
cost per set
100
marginal gain per set
200
no. of sets sold
10,000
Gain from cheap club sets
2,000,000
2,000,000

2,000,000

2,000,000

2,000,000

2,000,000

2,000,000

c. Sales loss from decremental high-priced club sets

price per set
1,000
cost per set
550
marginal gain per set
450
no. of sets decreased
-12,000
Loss from high-priced club
-5,400,000
-5,400,000

-5,400,000

-5,400,000

-5,400,000

-5,400,000

-5,400,000

Net gain from new product

(a) + (b) + (c)
Fixed cost
Depreciation
EBIT
tax (40%)
Net income
+ plus non-cash expense
Operating cashflow

14,600,000

14,600,000

14,600,000

14,600,000

14,600,000

14,600,000

14,600,000

7,000,000
2,200,000
5,400,000
2,160,000
3,240,000
2,200,000
5,440,000

7,000,000
2,200,000
5,400,000
2,160,000
3,240,000
2,200,000
5,440,000

7,000,000
2,200,000
5,400,000
2,160,000
3,240,000
2,200,000
5,440,000

7,000,000
2,200,000
5,400,000
2,160,000
3,240,000
2,200,000
5,440,000

7,000,000
2,200,000
5,400,000
2,160,000
3,240,000
2,200,000
5,440,000

7,000,000
2,200,000
5,400,000
2,160,000
3,240,000
2,200,000
5,440,000

7,000,000
2,200,000
5,400,000
2,160,000
3,240,000
2,200,000
5,440,000

(iii) Project cashflow -16,000,000

5,440,000

5,440,000

5,440,000

5,440,000

5,440,000

5,440,000

6,040,000

2
-10,560,000
5,440,000
-5,120,000

3
-5,120,000
5,440,000
320,000

4
320,000
5,440,000
5,760,000

solve for Payback period

Year 1
Investment
-16,000,000
-16,000,000
cash return
5,440,000
Remain investment
-10,560,000
Payback period = 4 years
solve for NPV
5,440,000
NPV =
-16,000,000
( 1 + 0.14)
NPV =
solve for IRR
NPV = 0 =
IRR =

5,440,000
( 1 + 0.14)2

5,440,000
( 1 + 0.14)3

5,440,000
( 1 + 0.14)4

5,440,000
( 1 + 0.14)5

5,440,000
( 1 + 0.14)6

6,040,000
( 1 + 0.14)7

5,440,000
( 1 + r)2

5,440,000
( 1 + r)3

5,440,000
( 1 + r)4

5,440,000
( 1 + r)5

5,440,000
( 1 + r)6

6,040,000
( 1 + r)7

6,638,737
-16,000,000
28.217%

5,440,000
( 1 + r)

Selected Solution to Chapter 11 : Project analysis and Evaluation

Q21

Scenario Analysis In the previous problem, you feel that the values are accurate to within only 10 percent. What are the best-case
and worst-case NPVs? (Hint: The price and variable costs for the two existing sets of clubs are known with certainty; only the sales
gained or lost are uncertain.)
Normal
New club
price per set
cost per set
no. of sets sold
Incremental cheap club sets
Decremental high-priced sets
Fixed cost
Scenario
New club
price per set
cost per set
no. of sets sold
Incremental cheap club sets
Decremental high-priced sets
Fixed cost
Scenario
Marginal gain from new clubs
Gain from cheap club sets
Loss from high-priced club
Net gain from new product
Depreciation
Fixed cost
EBIT
tax (40%) *
Net income
+ plus non-cash expense
Operating cashflow
NPV

Upper bound
+ 10%

Lower bound
- 10%

600
240
50,000
10,000
-12,000
7,000,000

660
264
55,000
11,000
-13,200
7,700,000

540
216
45,000
9,000
-10,800
6,300,000

Base case

Worse case

Best case

600
240
50,000
10,000
-12,000
7,000,000

540
264
45,000
9,000
-13,200
7,700,000

660
216
55,000
11,000
-10,800
6,300,000

Base case
18,000,000
2,000,000
-5,400,000
14,600,000
2,200,000
7,000,000
5,400,000
2,160,000
3,240,000
2,200,000
5,440,000
6,638,737

Worse case
12,420,000
1,800,000
-5,940,000
8,280,000
2,200,000
7,700,000
-1,620,000
-648,000
-972,000
2,200,000
1,228,000
-9,205,420

Best case
24,420,000
2,200,000
-4,860,000
21,760,000
2,200,000
6,300,000
13,260,000
5,304,000 * assume there's tax credit
7,956,000
2,200,000
10,156,000
24,378,777