Q. No.

Ex-1
2
3
4
Prob-1
2
3
4
5
6
7
8
9
10
11

Topic Covered
Present value of the project, internal rate of return, payback period
Incremental cash flows, incremental depreciation, PV of salvage value, tax shield, MACRS
Selection of projects with cummulative cash flows, economies realized in combination
NPV resulting from synergism
Payback Period & NPV
Critisism over ARR and payback period
Payback period, profitabilit index, IRR, NPV
IRR & Selection of projects
Selection of purchase of equipment, asset, analysis of various cash flows
Purchase of Equipment, MACRS & NPV analysis
NPV analysis and inclusion of working capital as outflow & its recovery at the end
Capital rationing & selection of the optimal strategy
Earnings after tax, cash flows and NPV analysis
Shortcommings of IRR, application of quadratic equation, dual IRR of a project
Shortcommings of IRR, investment with cash flow pattern having No IRR.

Q1Briarcliff Stove Company is considering a new product line to supplement

its range line. It is is anticipated that new product line will involve cash investment
of $700,000.00 at time 0 and $1,000,000.00 in year 1. After tax cash flows of $250,000
are expected in year 2, #300,000 in year 3, $350,000 in year 4, and $400,000 year
thereafter through year 10. Although the product line might be viable after 10 years,
the company prefers to be conservative and end all calculations at that time.

a- If the required rate of return is 15 percent, what is the net present value of the project?
is it acceptable?
b- What is the internal rate of return?
c- What would be the case if the required rate of return were 10 percent?
d- What is the project's payback period?

Q1aYear
0
1
2
3
4
5
6
7
8
9
10

Cash Flows
DF @ 15 %
700,000.00
1.0000
- 1,000,000.00
0.8696
250,000.00
0.7561
300,000.00
0.6575
350,000.00
0.5718
400,000.00
0.4972
400,000.00
0.4323
400,000.00
0.3759
400,000.00
0.3269
400,000.00
0.2843
400,000.00
0.2472
Net Present Value

PV
OR
700,000
869,565
189,036
197,255
200,114
198,871
172,931
150,375
130,761
113,705
98,874

Year
0
1
2
3
4
5-10

117,645

Since the NPV of the project is negative, we will reject it/ Unacceptable

Q1bYear
0
1
2
3
4
5
6
7
8
9
10

Cash Flows
DF @ 13 %
700,000.00
1.0000
- 1,000,000.00
0.8850
250,000.00
0.7831
300,000.00
0.6931
350,000.00
0.6133
400,000.00
0.5428
400,000.00
0.4803
400,000.00
0.4251
400,000.00
0.3762
400,000.00
0.3329
400,000.00
0.2946

PV
DF @ 14 %
700,000
1.0000
884,956
0.8772
195,787
0.7695
207,915
0.6750
214,662
0.5921
217,104
0.5194
192,127
0.4556
170,024
0.3996
150,464
0.3506
133,154
0.3075
117,835
0.2697

PV
- 700,000
- 877,193
192,367
202,491
207,228
207,747
182,235
159,855
140,224
123,003
107,898

14,116

- 54,145
X

IRR = A + (a/b) X (b-a)

Lower Rate
Higher Rate

0.13

14,116.38

Positive NPV
Negative NPV

0.13

68,261.59
0.21

0.13

0.0021
13.21%

Q1cYear
0
1
2
3
4
5
6
7
8
9
10

Cash Flows
DF @ 10 %
700,000.00
1.0000
- 1,000,000.00
0.9091
250,000.00
0.8264
300,000.00
0.7513
350,000.00
0.6830
400,000.00
0.6209
400,000.00
0.5645
400,000.00
0.5132
400,000.00
0.4665
400,000.00
0.4241
400,000.00
0.3855
Net Present Value

PV
700,000
909,091
206,612
225,394
239,055
248,369
225,790
205,263
186,603
169,639
154,217
251,850

Here the project has positive net present value, hence it becomes acceptable at 10 percent.
Q1dYear
0
1
2
3
4
5
6
7
8
9
10

Additional Working:
Q1c-

Cash Flows
700,000.00
- 1,000,000.00
250,000.00
300,000.00
350,000.00
400,000.00
400,000.00
400,000.00
400,000.00
400,000.00
400,000.00

Net Cash Flow

700,000
1,700,000
1,450,000
1,150,000
800,000
400,000
-

Discounted payback period:

======>

Pay Back period is 6 years.

Year
0
1
2
3
4
5
6
7
8
9
10

Cash Flows
DF @ 10 %
700,000.00
1.0000
- 1,000,000.00
0.9091
250,000.00
0.8264
300,000.00
0.7513
350,000.00
0.6830
400,000.00
0.6209
400,000.00
0.5645
400,000.00
0.5132
400,000.00
0.4665
400,000.00
0.4241
400,000.00
0.3855
Net Present Value

PV
700,000
909,091
206,612
225,394
239,055
248,369
225,790
205,263
186,603
169,639
154,217

Cumm. CF
700,000
- 1,609,091
- 1,402,479
- 1,177,085
938,030
689,662
463,872
258,609
72,006
97,633

251,850

Because of discounted cash flows the pay back period extends from 6 to 8.58 years

of the project?

Cash Flows
$
(700,000.00)
(1,000,000.00)
250,000.00
300,000.00
350,000.00
400,000.00
Net Present Value

e at 10 percent.

riod is 6 years.

0.01
0.01

1
1
1
1
1
1
1
1
0.576
8.58
Years

Q2Carbide Chemical Company is considering the replacement of two old machines

with a new more efficient machine, The old machine could be sold for $70,000 in the
secondary market. The depreciated book value is $120,000 with a remaining useful and
depreciable life of 8 years. Straight-line depreciation is used on these machines. The
new machine can be purchased and installed for $480,000. It has useful life of 8 years,
and at the end of which a salvage value of $40,000 is expected. The machine falls in 5-year
property class for accelerated cost recovery (depreciation) purposes. Due to its greater
efficiency , the machine is expected to result in incremental annual saving of $120,000.
The company's corporate tax rate is 34 percent, and if a loss occurs in any year on the project,
it is assumed that company will get a tax credit of 34 percent for such class.
a- What are the incremental cash flows over the eight years and what is the incremental cash
flow at time 0?
b- What is the project's net present value If the require date of return is 14 percent?

120,000
96,000
15,000

120,000
153,600
15,000

120,000
92,160
15,000

Incr. Dep

81,000

138,600

77,160

3-

Profit BT

39,000 -

18,600

42,840

4-

Tax @ 34 %

13,260 -

6,324

14,566

5-

Op. Cash Flows

106,740

126,324

105,434

6-

Salvage Value (1-T)

7-

Net Cash Flows

106,740

126,324

105,434

8-

DF @ 14%

0.877
93,632

0.769
97,202

0.675
71,165

1120000 28
15000

91011-

Particular
0
Incremental
annual Savings
New Depreciation
Old Depreciation

Cost of machine
Sale of Old Machine
Tax Savings

1.0
- 480,000.00
70,000.00
17,000.00
- 393,000.00

Step-1
Step-2

Savings are taken as EBIT,

Incremental depreciation is calculated,

Step-3
Step-4
Step-5
Step-6
Step-7
Step-8
Step-9
Step-10

Saving less incremental depreciation gives profit before taxes (EBT),

Tax rate is applied ,
Positive or negative Operating cash flows are obtained,
Salvage value is considered at the end,
Discounting is applied to determine the present values,
Other costs and incremental cash flows (after tax) are taken into account at time zero,
Sum of the all discounted cash flows gives positive or negative NPV,
Decision for acceptance or rejection is taken.

e sold for $70,000 in the

ith a remaining useful and
n these machines. The
has useful life of 8 years,
d. The machine falls in 5-year
rposes. Due to its greater
nnual saving of $120,000.
occurs in any year on the project,

nd what is the incremental cash

of return is 14 percent?

120,000
55,296
15,000

120,000
55,296
15,000

120,000
27,648
15,000

120,000

120,000

15,000

15,000

40,296

40,296

15,000 -

15,000

79,704

79,704

107,352

135,000

135,000

27,099

27,099

36,500

45,900

45,900

92,901

92,901

83,500

74,100

74,100

12,648 -

Total

26,400
92,901

92,901

83,500

74,100

100,500

0.592
55,005

0.519
48,250

0.456
38,042

0.400
29,613

0.351
35,231
-

NPV
Conclusion: Project is acceptable

468,139
480,000
70,000
17,000
75,139

are taken into account at time zero,

Q3The Platte River Perfect Cooker Company is evaluating three investment situations:
(1) produce a new line of aluminum skillets,(2) expand its existing cooker line to include
several new sizes, and (3) develop a new, higher quality line of cookers. If only the
project in question is undertaken, the expected value and the amounts of investment
required are:
Investment
Present Value of
Project
Required
Future Cash flows
1
200,000.00
290,000.00
2
115,000.00
185,000.00
3
270,000.00
400,000.00
If project 1 and 2 are jointly undertaken, there will be no economies; the investment required
and present values will simply be the sum of the parts. With project 1 & 3 economies are possible
in investment because one of the machines acquired can be used in both production processes.
The total investment required for project 1 & 3 combined is $440,000. If project 2 and 3 are
undertaken, there are economies to be achieved in marketing and producing the product but, not
in investment. The expected present value for future cash flows for project 2 & 3 is $620,000.
If the three projects are undertaken simultaneously, the economies noted will still hold.
however, a $125,000 extension on plant will be necessary, as space is not available for all the three
projects. Which project or projects should be chosen?

Ans3Project 1 & 3
Investment required
PV of Cash Flows
(290000 + 400000)

-440,000.00
690,000.00

Net Present Value

250,000.00

Investment required
(115000+270000)
PV of Cash Flows

-385,000.00

Net Present Value

235,000.00

Investment required
(115000+440000)
Add. Inv. for extension

-555,000.00

Project 2 & 3

620,000.00

Project 1, 2 & 3

125,000.00

PV of Cash Flows
(620000+290000)
Net Present Value
Conclusion:

910,000.00

230,000.00

Project 2 & 3 should be undertaken as NPV is the highest

in this case

Q4Inshell Corporation is considering the acquisition of Fourier-Fox Inc. Which is in a

related line of business. Fourier-Fox Inc. presently has a cash flow of $2 million.
per year. With merger synergism would be expected to result in growth rate of
this cash flow of 15 percent per year for 10 years, at the end of which a level cash
flows would be expected. To sustain the cash flow stream, Inshell will need to invest
$1 million in cash annually. For the purpose of analysis and to be conservative, Inshell
limits its calculations of cash flows to 25 years.
a- What is expected cash flows Inshell would realize from this acquisition?
b- If its required rate of return is 18 percent, what is the maximum price Inshell should pay?

Ans4Year
1
2
3
4
5
6
7
8
9
10-25

Cash Flows
$
2,300,000
2,645,000
3,041,750
3,498,013
4,022,714
4,626,122
5,320,040
6,118,046
7,035,753
8,091,115

A
Investment
Net Cash Flows
DF @ 18%
-$
1,000,000 $
1,300,000 0.847458
1,000,000
1,645,000 0.718184
1,000,000
2,041,750 0.608631
1,000,000
2,498,013 0.515789
1,000,000
3,022,714 0.437109
1,000,000
3,626,122 0.370432
1,000,000
4,320,040 0.313925
1,000,000
5,118,046 0.266038
1,000,000
6,035,753 0.225456
1,000,000
7,091,115 1.163884
Net present Value

Conclusion:
Since the present value of the project is positive, it is acceptable

B
Present Value
$
1,101,695
$
1,181,413
$
1,242,672
$
1,288,447
$
1,321,256
$
1,343,230
$
1,356,169
$
1,361,595
$
1,360,797
$
8,253,236
$

19,810,511

Prob1Lobears Inc. is considering two investment proposals, labeled project A and project B,
with the characteristics shown in the accompanying table:
Project A
Profit
Net Cash
Period
Cost
After Tax
Flows
Using DF 0 perfect,
$
25 percent,
9,000.00100$percent and
- 400
$ percent, we have
1
$ 1,000.00 $
5,000.00
2
$ 1,000.00 $
4,000.00
3
$ 1,000.00 $
3,000.00

Cost
$ 12,000.00 $
$
$
$

Project B
Profit
Net Cash
After Tax
Flows
1,000.00 $ 5,000.00
1,000.00 $ 5,000.00
4,000.00 $ 8,000.00

for each project compute its average rate of return, its payback period, and its present value
using a discount rate of 15 percent.

Ans1Avg. rate of return =

Profit after Tax/3 Years

Average investment

Project A

$
$

1,000.00 =
4,500.00

22.22%

Project B

$
$

2,000.00 =
6,000.00

33.33%

Second Approach
Avg. rate of return =

Profit after Tax/3 Years

Initial investment

Project A

$
$

1,000.00 =
9,000.00

11.11%

Project B

$
$

2,000.00 =
12,000.00

16.67%

Pay Back Period

Project-1
Period

Cost
0
1
2
3

$
$
$
$

Project-2
Period

Cumm. CF
-9,000 $
-9,000
5,000 $
-4,000
4,000 $
3,000
2 years

0
1
2
3

Cost
Cumm. CF
$ -12,000.00 $ -12,000.00
$ 5,000.00 $ -7,000.00
$ 5,000.00 $ -2,000.00
$ 8,000.00
2.00

0.25
2.25 Years

Ans3bNet Present Value: Project -1

Year
0
1
2
3

Net Present Value: Project -2

Cash Flows
9,000.00
5,000
4,000
3,000

DF 15%
1
0.870
0.756
0.658

PV
-

9,000
4,348
3,025
1,973
345

Year
0
1
2
3

Cash Flows
- 12,000.00
5,000
5,000
8,000

DF 15%
1
0.870
0.756
0.658

PV
- 12,000
4,348
3,781
5,260
1,389

Prob2What criticism may be offered against the average-rate-of-return method as a

capital budgeting technique? What criticism may be offered against payback period?

Ans2Average rate of return

- It also ignores the time value of money.
- Based on accounting income rather than cash flows
Payback period
- The pay back method ignores the time value of money.
- It also ignores the cash flows after pay back period
Discounted pay back method is used to over come the time value of money problem
by adding positive discounted cash flow coming from the profits of the project.

Prob3Zaire Electronics can make either of the two investments at time 0. Assuming
a required rate of return of 14 percent, determine each project's (a) payback period,
(b) the net present value, ( c ) the profitability index, (d) the internal rate of return.
Assume the accelerated cost recover system for depreciation and that asset falls in
5-year property class and corporate tax rate is 34 percent.
Using DF 0 perfect, 25 percent, 100 percent and 400 percent, we have
Project
Project
Cost
1
2
3
4
A
$ 28,000.00 $ 8,000.00 $ 8,000.00 $ 8,000.00 $ 8,000.00 $
B
$ 20,000.00 $ 5,000.00 $ 5,000.00 $ 6,000.00 $ 6,000.00 $

5
8,000.00 $
7,000.00 $

6
8,000.00 $
7,000.00 $

7
8,000.00
7,000.00

Ans3-

Project A's Cost

-28000
B
C = (B x Dep )

A
Year
1
2
3
4
5
6
7

Savings
Depreciation
8000
-5600
8000
-8960
8000
-5376
8000
-3225.6
8000
-3225.6
8000
-1612.8
8000

Project B's Cost

Savings
1
2
3
4
5
6
7

5000
5000
6000
6000
7000
7000
7000

E = D x Tax

F=B-E

Tax

Cash Flows
7,184
8,326
7,108
6,377
6,377
5,828
5,280

EBT
2400
-960 2624
4774.4
4774.4
6387.2
8000

-20000
B
C = (B x Dep )

A
Year

D = B-C

D = B-C

Depreciation
-4000
-6400
-3840
-2304
-2304
-1152

816
326
892
1,623
1,623
2,172
2,720

E = D x Tax

EBT
Tax
1000
-1400 2160
3696
4696
5848
7000

340
476
734
1,257
1,597
1,988
2,380

F=B-E

Recovery
Year

3-Year
Property
1
2
3
4
5
6

Recovery
Year

Cash Flows
4,660
5,476
5,266
4,743
5,403
5,012
4,620

0.2
0.32
0.192
0.1152
0.1152
0.0576

20
32
19.2
11.52
11.52
5.76

3-Year
Property
1
2
3
4
5
6

0.2
0.32
0.192
0.1152
0.1152
0.0576

20
32
19.2
11.52
11.52
5.76

Ans3aPay Back Period: project A

Year
0
1
2
3
4
5
6
7

Cash Flows
- 28,000.00
7,184
8,326
7,108
6,377
6,377
5,828
5,280

Pay Back Period: project B

Cumm. C.F
- 28,000.00
- 20,816.00
- 12,489.60
5,381.76

Year
0
1
2
3
4
5
6
7

Cash Flows
- 20,000.00
4,660
5,476
5,266
4,743
5,403
5,012
4,620

3.84 Years

Ans3bNet Present Value: Project -1

Year
0
1
2
3

Cash Flows
- 28,000.00
7,184
8,326
7,108

Cumm. C.F
- 20,000.00
- 15,340.00
- 9,864.00
- 4,598.40

3.97 Years

Net Present Value: Project -1

DF 14%
1
0.877
0.769
0.675

PV
28,000
6,302
6,407
4,798

Year
0
1
2
3

Cash Flows
- 20,000.00
4,660
5,476
5,266

DF 14%
1
0.877
0.769
0.675

PV
20,000
4,088
4,214
3,554

4
5
6
7

6,377
6,377
5,828
5,280

0.592
0.519
0.456
0.400

3,776
3,312
2,655
2,110

4
5
6
7

4,743
5,403
5,012
4,620

0.592
0.519
0.456
0.400

1,359

1,600

Ans3cProfitability Index =

Project A

Present Value of Cash Inflows

Present Value of Cash outflows
=

29,359
28,000

Ans3dInternal Rate of Return: Project A

Year
0
1
2
3
4
5
6
7

Project B

1.05

Cash Flows
- 28,000.00
7,184
8,326
7,108
6,377
6,377
5,828
5,280

DF 15%
1
0.870
0.756
0.658
0.572
0.497
0.432
0.376

PV
28,000
6,247
6,296
4,674
3,646
3,170
2,520
1,985
537

DF 16%
1
0.862
0.743
0.641
0.552
0.476
0.410
0.354

PV
28,000
6,193
6,188
4,554
3,522
3,036
2,392
1,868
247

IRR = A + (a/b) X (b-a)

Lower Rate
Higher Rate
Positive NPV
Negative NPV

0.15

21,600
20,000
1.08

537.39 X

0.01

0.15

784.47
0.69 X

0.01

0.15

0.0069
15.69%

2,808
2,806
2,283
1,846

Prob4Two mutually exclusive projects have project cash flows as follows:

Years
Project
A
B

0
1
$ -10,000.00 $ 5,000.00 $
$ -10,000.00 $
$

2
3
4
5,000.00 $ 5,000.00 $ 5,000.00
$
$ 30,000.00

a- determine the internal rate of return of each project.

b- Assume a required rate of return of 10 percent, determine the net present value
of the project.
c- Which project would you select, what assumptions are inherent in your decision?
Ans4aInternal Rate of Return: Project A

Year
0
1
2
3
4

Cash Flows
- 10,000.00
5,000
5,000
5,000
5,000

DF 34%
1
0.746
0.557
0.416
0.310

PV
10,000
3,731
2,785
2,078
1,551
145

IRR = A + (a/b) X (b-a)

Lower Rate

DF 35%
1
0.741
0.549
0.406
0.301

Higher Rate

0.34

145 X

Positive NPV
Negative NPV

0.34

160
0.90 X

0.34

0.0090
34.90%

Internal Rate of Return: Project B

Year
0
1
2
3
4

Cash Flows
- 10,000.00
30,000

DF 31%
1
0.763
0.583
0.445
0.340

PV
10,000
10,187

DF 32%
1
0.758
0.574
0.435
0.329

187
IRR = A + (a/b) X (b-a)
Lower Rate
Higher Rate
Positive NPV
Negative NPV

0.31

187 X

0.31
0.31

+
+

305
0.61 X
0.0061
31.61%

Ans4bNet Present Value: Project -1

Year
0
1
2
3
4

Cash Flows
- 10,000.00
5,000
5,000
5,000
5,000

DF 10%
1
0.909
0.826
0.751
0.683

PV
10,000
4,545
4,132
3,757
3,415
5,849

Ans4c-

Summary

Project
A
B

NPV
5,849
10,490

IRR
34.90%
31.61%

On theoretical grounds, we will accept project B having higher present value in absolute terms.
Where it is assumed that appropriate reinvestment rate is the discount rate of 10 percent.
However, on practical grounds, IRR has preference. The difference in answers is due to different rates implied for PV and IRR.

PV
- 10,000
3,704
2,743
2,032
1,505
-

15

0.01
0.01

PV
- 10,000
9,882

118

0.01
0.01

Net Present Value: Project -1

Year
0
1
2
3
4

Cash Flows
- 10,000.00
30,000

DF 10%
PV
1
- 10,000
0.909
0.826
0.751
0.683
20,490
10,490

es implied for PV and IRR.

Prob5The city of San Joe needs a number of new special purpose trucks. It has received several bids
and has closely evaluated the performance characteristics of various trucks. Each petter bit truck
costs $74,000, but, it is "Top-of-the-line" equipment, The truck has a life of 8 years. Assuming that
the engine is rebuilt in the fifth year. Maintenance costs of $2,000 are expected a year in the first
four years, followed by total maintenance and rebuilding costs of $13,000 in the fifth year.
During the last three years Maintenance costs are expected to be $4,000 a year. At the end of 8 years,
the truck will have an estimated scrap value of $9,000.
A bid from the Bulldog Truck, Inc., is for $59,000 a truck, However, maintenance costs for this truck
will be higher. In the first year they are expected to be $3,000 and this amount is expected to
increase y $1,500 a year through the eighth year. In the fourth year, the engine need a rebuilt, and
this will cost the company $15,000 in additional to maintenance costs in that year. At the end of 8
years, the bulldog truck will have an scrap value of $5,000.
The last bid, Best Tractor and Trailer Company, has agreed to sell San Joe at $44,000 each. Maintenance
costs in the first 4 years are expected to be $4,000 the first year and are expected to increase by $1,000
a year. For San Joe's purpose the truck has a life of only 4 years. At that time it can be traded-in for a
new Best Truck, which is expected to costs $52,000. The likely traded-in value of the old truck is $15,000.
During years 5 through 8, the second truck is expected to have a maintenance costs of $5,000 in year 5,
and these are expected to increase by $1,000 each year. At the end of 8 years, the second truck is expected
to have a resale salvage value of $18,000.
a- If the San Joe's costs of funds is 8 percent, which bid should it accept? Ignore any tax considerations as
the city pays no taxes.
b- If it opportunity costs were 15 percent, would you answer change?

Ans5a
Year
0
1
2
3
4
5
6
7
8
8

Petter Bit Truck

Cash Flows DF 8%
74000
1
2000
0.926
2000
0.857
2000
0.794
2000
0.735
13000
0.681
4000
0.630
4000
0.583
4000
0.540
-9000
0.540

PV
Year
74,000
0
1,852
1
1,715
2
1,588
3
1,470
4
8,848
5
2,521
6
2,334
7
2,161
8
4,862
8

Bulldog truck
Cash Flows DF 8%
59000
1
3000 0.926
4500 0.857
6000 0.794
22500 0.735
9000 0.681
10500 0.630
12000 0.583
13500 0.540
-5000 0.540

91,625

PV
Year
59,000
0
2,778
1
3,858
2
4,763
3
16,538
4
6,125
5
6,617
6
7,002
7
7,294
8
2,701
8

Best Truck
Cash Flows DF 8%
44000
1
4000 0.926
5000 0.857
6000 0.794
44000 0.735
5000 0.681
6000 0.630
7000 0.583
8000 0.540
-18000 0.540

111,273

PV
44,000
3,704
4,287
4,763
32,341
3,403
3,781
4,084
4,322
- 9,725
94,960

Petter Bit Truck should be selected having the lowest PV of cash outflows

Ans5b
Year
0
1
2
3
4
5
6
7
8
8

Petter Bit Truck

Cash Flows DF 15%
74000
1
2000
0.870
2000
0.756
2000
0.658
2000
0.572
13000
0.497
4000
0.432
4000
0.376
4000
0.327
-9000
0.327

PV
Year
74,000
0
1,739
1
1,512
2
1,315
3
1,144
4
6,463
5
1,729
6
1,504
7
1,308
8
2,942
8

Bulldog truck
Cash Flows DF 15%
59000
1
3000 0.870
4500 0.756
6000 0.658
22500 0.572
9000 0.497
10500 0.432
12000 0.376
13500 0.327
-5000 0.327 -

87,772

PV
Year
59,000
0
2,609
1
3,403
2
3,945
3
12,864
4
4,475
5
4,539
6
4,511
7
4,413
8
1,635
8

Best Truck
Cash Flows DF 15%
PV
44000
1
44,000
4000 0.870
3,478
5000 0.756
3,781
6000 0.658
3,945
44000 0.572
25,157
5000 0.497
2,486
6000 0.432
2,594
7000 0.376
2,632
8000 0.327
2,615
-18000 0.327 - 5,884

98,125

Best Truck should be selected having the lowest PV of cash outflows

The point to emphasize is that with higher discount rate, more distant cash flows become less important, relative to the initial
outlay. As a result, the bid with the lowest initial investment, Best should now be accepted.

84,804

Thoma Pharmaceutical Company may buy DNA testing equipment costing $60,000.
This equipment is expected to reduce clinical staff labor cost by $20,000 annually.
The equipment has a useful life of 5 years, but, falls into 3 years property class for
cost recovery (depreciation) purposes. No salvage value is expected at the end. The
corporate tax rate for Thoma is 38 percent, and its required rate of return is 15 percent.
(If profits before tax are negative in any year, the firm will receive a tax credit of 38
value of the project? Is it acceptable?

Ans6Years
0
1
2
3
4
5

Outlay/
Savings
60,000
20,000
20,000
20,000
20,000
20,000

Dep
0
-19998
-26670
-8886
-4446

EBT
0
2
-6670
11114
15554
20000

Tax
0
1
-2535
4223
5911
7600

Cash Flow
-60000
19999
22535
15777
14089
12400

DF
1
0.870
0.756
0.658
0.572
0.497

Net Present Value

Since the Net present value of the project is negative, we will reject it.

Recovery 3-Year
Year
Property
1
33.33
2
44.45
3
14.81
4
7.41

0.3333
0.4445
0.1481
0.0741

PV
- 60,000
17,391
17,039
10,373
8,056
6,165
-

976

Prob7In problem 7, suppose 6 percent inflation in labor cost saving is expected

over the last four years, so that savings n the first year are $20,000, savings
in the second year are $2,100, and so forth.
a- If the required rate of return is still 15 percent, what is the net present
value of the project? Is it still acceptable?
b- if the working capital requirement of $10,000 are required in addition
to the cost of the equipment and this additional investments were needed
over the life of the project, what would be the effect on net present value
of the project? (All other things remain as in part a.)

Ans7aYears
0
1
2
3
4
5

Cash Flows
-60000
20000
21200
22472
23820
25250

Dep
-19998
-26670
-8886
-4446

EBT
2
-5470
13586
19374
25250

Tax
1
-2079
5163
7362
9595

Cash Flow
-60000
19999
23279
17309
16458
15655

DF
1
0.870
0.756
0.658
0.572
0.497

PV
- 60,000
17,391
17,602
11,381
9,410
7,783

Net Present Value

3,567

Now the project is acceptable as it has positive Net present Value.

Ans7bYears
0
1
2
3
4
5
5

Cash Flows
-70000
20000
21200
22472
23820
25250
10000

Dep
-19998
-26670
-8886
-4446

EBT
2
-5470
13586
19374
25250

Tax
1
-2079
5163
7362
9595

Cash Flow
DF
-70000
1
19999 0.870
23279 0.756
17309 0.658
16458 0.572
15655 0.497
10000 0.497
Net Present Value

PV
- 70,000
17,391
17,602
11,381
9,410
7,783
4,972
- 1,461

The project becomes again unacceptable as the NPV is negative with

inclusion of Working Capital at beginning and its recovery at end

Prob8The lake Thoe Ski Resort is studying a half-dozen of capital improvement projects.
It has allocated $1 million for capital budgeting purposes. The following proposals
and associated profitability indexes have been determined. The projects themselves
are independent of on an another.
Profitability
Project
Amount
Index
Extend Ski lift 3
500,000
1.21
Build a new sports shop
150,000
0.95
Extend Ski lift 4
350,000
1.2
Build a new restaurant
450,000
1.18
Add to new housing complex
200,000
1.2
Build an indoor skating rink
400,000
1.05

a- With strict capital rationing, which of these investment should be undertaken?

b- If this an optimal strategy?
Ans8a

S.No.
1
2
3
4
5
6

Project
Extend Ski Lift 3
Build a new sports shop
Extend Ski lift 4
Build a new restaurant
Add to new housing complex
Build an indoor skating rink

Amount
500,000.00
150,000.00
350,000.00
450,000.00
200,000.00
400,000.00

Profitability
Index
1.21
0.95
1.20
1.18
1.20
1.05

Cash Flow
605000
142500 420000
531000
240000
420000

Present Value
105,000.00
7,500.00
70,000.00
81,000.00
40,000.00
20,000.00

605000
420000

Present Value
105,000.00
70,000.00

Selecting project with the highest Profitability Index and present Value

S.No.
1
3

Project
Extend Ski Lift 3
Extend Ski lift 4

Amount
500,000.00
350,000.00

Profitability
Index
1.21
1.20

Cash Flow

850,000.00

175,000.00

However, it would be better to utilize the full budget, even though the most profitable project
is foregone

Selecting the project that maximizes the full budget, we have

S.No.
3
4
5

Project
Extend Ski lift 4
Build a new restaurant
Add to new housing complex

Amount
350,000.00
450,000.00
200,000.00

Profitability
Index
1.20
1.18
1.20

Cash Flow

1,000,000.00
This is going to maximize the full budget and thus, results in higher cumulative present value.

Ans8b
No, The optimal strategy is one that all the projects. If there is capital rationing problem, then a higher
discount rate should be used to assess the projects and that more accurately reflects the costs of financing

420000
531000
240000

Present Value
70,000.00
81,000.00
40,000.00
191,000.00

Prob9The R.Z Frank Company may acquire Aziz Car Leasing Company. Frank estimates
that Aziz will provide incremental net income after taxes of $2 million in the
first year, $3million in the second year, $4 million in the third year, $5 million in each of the
year 6 through 6, and $6 million annually thereafter. Owning the need to replenish the
fleet, heavier than usual investments are required in the first 2 years. Capital Investment
and depreciation charges are expected to be (in millions):

Years
Capital Investment
Depreciation

1
5
3

2
5
4

3
4
4

4
4
4

5
4
4

6
4
4

DF
0.870
0.756
0.658
0.572
0.497
0.432
2.882

Present Value
1,512,287
2,630,065
2,858,766
2,485,884
2,161,638
17,293,104

The overall required rate of return is 15 percent. Compute the present value of acquisition based
on these expectations. If you had a range of possible outcomes, how would you obtain the information
necessary to analyze the acquisition?

Year
1
2
3
4
5
6
7 ON

EAT
2,000,000
3,000,000
4,000,000
5,000,000
5,000,000
5,000,000
6,000,000

Dep
3,000,000
4,000,000
4,000,000
4,000,000
4,000,000
4,000,000
4,000,000

Cash Flows
5,000,000
7,000,000
8,000,000
9,000,000
9,000,000
9,000,000
10,000,000

Cap. Inv
5,000,000
5,000,000
4,000,000
4,000,000
4,000,000
4,000,000
4,000,000

Present Value
2,000,000
4,000,000
5,000,000
5,000,000
5,000,000
6,000,000
Net Present Value

Additional Notes:
We can more thoroughly assess the investment if the risk-free rate is used.
This will reduce the risk of double counting.
The expected values of the probability distribution of possible present values
is a weighted average i.e. Probability of occurrence X adjusted present values)
Also Standard deviation may also be calculated from the information given and
the profitability of the investment may be assessed.

28,941,744

7 ON
4
4

Prob10An investment has an outlay of $800 today, an inflow of $5,000 at the end of 1 year,
and an outflow of $8,000 at the end of 2 years. What is its internal rate of return?
if the initial outlay were $1,250, what would be the IRR? (This problem is an exception
rather than the rule)
Ans10A-

If initial Investment in $800

1
(1+ r)

1
(1+ r)

2000
10000

1
(1+ r)

0.2

5 =

400%

Applying the Quadratic Formula

1
(1+ r)

1
(1+ r)

-8000
10000

1
(1+ r)

-0.8

1.25 =

25%

The Problem highlights one of the shortfalls in IRR investment appraisal analysis
Dual IIR exists for the problem of 400% and 25 %

Ans10A-

If initial Investment in $1250

Applying the Quadratic Formula
1
(1+ r)

1
(1+ r)

5000
10000

1
(1+ r)

0.5

2 =

Applying the Quadratic Formula

1
(1+ r)

-5000

100%

(1+ r)

10000

1
(1+ r)

-0.5

2 =

100%

if the initial investment were $1,250, instead of $800, we see unique IRR

Prob11An investment has a cash flow of $200 today, an out flow of $300 at the end of
1 year , an inflow of $400 at the end of 2 years. What is the internal rate of return?

Ans11We can try multiple discount factors here to see their impact

Using 0 percent discount rate, we have:

Year
CF
DF
PV
0
200
1
200
1
-300
1
-300
2
400
1
400
NPV

300

Using 25 percent discount rate, we have:

Year
CF
DF
PV
0
200
1
200
1
-300
0.8
-240
2
400
0.64
256
NPV

216

Using 100 percent discount rate, we have:

Year
CF
DF
PV
0
200
1
200
1
-300
0.5
-150
2
400
0.25
100
NPV

150

Using 400 percent discount rate, we have:

Year
CF
DF
PV
0
200
1
200
1
-300
0.2
-60
2
400
0.04
16
NPV

DF
=1/(1)
=1/((1+1)^1)
=1/((1+1)^2)

DF
=1/(1)
=1/((1+4)^1)
=1/((1+4)^2)

156

Conclusion:
At all the interest rates, present values of cash inflow exceeds the present value
of cash outflows, so there is no internal rate of return.