Chapter 07 - Discounted Cash Flow Techniques

Chapter 07
Discounted Cash Flow Techniques

Multiple Choice Questions

1. Which of the following is not an important step in the financial evaluation of an investment
opportunity?
A. Calculate a figure of merit for the investment.
B. Estimate the accounting rate of return for the investment.
C. Estimate the relevant cash flows.
D. Compare the figure of merit to an acceptance criterion.
E. All of the above are important steps.

2. Which of the following figures of merit might not use all possible cash flows in its
calculations?

I. Payback period
II. Internal rate of return
III. Net present value (NPV)
IV. Accounting rate of return
A. III only
B. I & III only
C. II & III only
D. I & IV only
E. III & IV only
F. I, II, III, and IV

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3. Which of the following figures of merit does not directly take into consideration the time
value of money?

I. Payback period
II. Internal rate of return
III. Net present value (NPV)
IV. Accounting rate of return
A. IV only
B. I & III only
C. II & III only
D. I & II only
E. I & IV only
F. I, II, III, and IV

4. Ian is going to receive $20,000 six years from now. Sunny is going to receive $20,000 nine
years from now. Which one of the following statements is correct if both Ian and Sunny apply
a 7 percent discount rate to these amounts?
A. The present values of Ian and Sunny's monies are equal.
B. In future dollars, Sunny's money is worth more than Ian's money.
C. In today's dollars, Ian's money is worth more than Sunny's.
D. Twenty years from now, the value of Ian's money will be equal to the value of Sunny's
money.
E. Sunny's money is worth more than Ian's money given the 7 percent discount rate.
F. None of the above.

5. You plan to buy a new Mercedes four years from now. Today, a comparable car costs
$82,500. You expect the price of the car to increase by an average of 4.8 percent per year over
the next four years. How much will your dream car cost by the time you are ready to buy it?
A. $98,340.00
B. $98,666.67
C. $99,517.41
D. $99,818.02
E. $100,023.16
F. None of the above.

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Chapter 07 - Discounted Cash Flow Techniques

6. Your grandmother invested a lump sum 26 years ago at 4.25 percent interest. Today, she
gave you the proceeds of that investment which totaled $51,480.79. How much did she
originally invest?
A. $15,929.47
B. $16,500.00
C. $17,444.86
D. $17,500.00
E. $17,999.45
F. None of the above.

7. Naomi plans on saving $3,000 a year and expects to earn an annual rate of 10.25 percent.
How much will she have in her account at the end of 45 years?
A. $1,806,429
B. $1,838,369
C. $2,211,407
D. $2,333,572
E. $2,508,316
F. None of the above.

8. You are the beneficiary of a life insurance policy. The insurance company informs you that
you have two options for receiving the insurance proceeds. You can receive a lump sum of
$200,000 today or receive payments of $1,400 a month for 20 years. You can earn a 6 percent
annual rate on your money, compounded monthly. Which option should you take and why?
A. You should accept the monthly payments because they are worth $209,414 to you.
B. You should accept the $200,000 lump sum because the monthly payments are only worth
$16,057 to you today.
C. You should accept the monthly payments because they are worth $336,000 to you.
D. You should accept the $200,000 lump sum because the monthly payments are only worth
$189,311 to you today.
E. You should accept the $200,000 lump sum because the monthly payments are only worth
$195,413 to you today.
F. None of the above.

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9. Your brother will borrow $17,800 to buy a car. The terms of the loan call for monthly
payments for 5 years at an 8.6 percent annual interest rate, compounded monthly. What is the
amount of each payment?
A. $287.71
B. $296.67
C. $301.12
D. $342.76
E. $366.05
F. None of the above.

10. EAC Nutrition offers a 9.5 percent coupon bond with annual payments, maturing 11 years
from today. Your required return is 11.2 percent. What price are you willing to pay for this
bond if the face (or par) value is $1,000?
A. $895.43
B. $896.67
C. $941.20
D. $946.18
E. $953.30
F. None of the above.

11. A project will produce after-tax operating cash inflows of $3,200 a year for 5 years. The
after-tax salvage value of the project is expected to be $2,500 in year 5. The project's initial
cost is $9,500. What is the net present value of this project if the required rate of return is 16
percent?
A. -$311.02
B. $2,168.02
C. $4,650.11
D. $9,188.98
E. $21,168.02
F. None of the above.

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12. Which of the following should be included in the analysis of a new product?

I. Money already spent for research and development of the new product
II. Reduction in sales for a current product once the new product is introduced
III. Increase in working capital needed to finance sales of the new product
IV. Interest expense on the loan used to finance the new product launch
A. II and III only
B. II and IV only
C. I, II, and III only
D. II, III, and IV only
E. I, II, III, and IV
F. None of the above.

13. Pro forma free cash flows for a proposed project should:

I. exclude the cost of employing existing assets that could be sold anyway.
II. exclude interest expense.
III. include the depreciation tax shield related to the project.
IV. exclude any required increase in operating current assets.
A. I and II only
B. II and III only
C. II and IV only
D. I, III, and IV only
E. I, II, III, and IV
F. None of the above.

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14. Which of the following statements related to the internal rate of return (IRR) are correct?

I. The IRR is the discount rate at which an investment's NPV equals zero.
II. An investment should be undertaken if the discount rate exceeds the IRR.
III. The IRR tends to be used more than net present value simply because its results are easier
to comprehend.
IV. The IRR is the best tool available for deciding between mutually exclusive investments.
A. I and II only
B. I and III only
C. II and III only
D. I, II, and IV only
E. I, II, III, and IV
F. None of the above.

15. You plan to pay $50 for a share of preferred stock that pays a $2.40 dividend per year
forever. What annual rate of return will you realize?
A. 0.48 percent
B. 2.40 percent
C. 4.80 percent
D. 5.10 percent
E. 20.83 percent
F. None of the above.

16. Sol's Sporting Goods is expanding, and as a result expects additional operating cash flows
of $26,000 a year for 4 years. This expansion requires $39,000 in new fixed assets. These
assets will be worthless at the end of the project. In addition, the project requires an additional
$3,000 of net working capital throughout the life of the project; Sol expects to recover this
amount at the end of the project. What is the net present value of this expansion project at a 16
percent required rate of return?
A. $18,477.29
B. $21,033.33
C. $28,288.70
D. $29,416.08
E. $32,409.57
F. None of the above.

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17. What is the benefit-cost ratio for an investment with the following cash flows at a 14.5
percent required return?

A. 0.94
B. 0.98
C. 1.02
D. 1.06
E. 1.11
F. None of the above.

18. When making a capital budgeting decision, which of the following is/are NOT relevant?

I. The size of a cash flow.

II. The risk of a cash flow.
III. The accounting earnings from a cash flow.
IV. The timing of a cash flow.
A. I only
B. II only
C. III only
D. II and III only
E. III and IV only
F. They are all relevant.

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Short Answer Questions

19. An investment costing $100,000 promises an after-tax cash flow of $36,000 per year for 6
years.

a. Find the investment's accounting rate of return and its payback period.
b. Find the investment's net present value at a 15 percent discount rate.
c. Find the investment's benefit-cost ratio (profitability index) at a 15 percent discount rate.
d. Find the investment's internal rate of return.
e. Assuming the required rate of return on the investment is 15 percent, which of the above
figures of merit indicate the investment is attractive? Which indicate it is unattractive?

20. At $1,000 par value, 10 percent coupon bond matures in 20 years. If the price of the bond
is $1,196.80, what is the yield to maturity on the bond? Assume interest is paid annually.

21. Ten years ago you invested $1,000 for 10 shares of Steeze, Inc. common stock. You sold
the shares recently for $2,000. While you owned the stock it paid $10.08 per share in annual
dividends. What was your rate of return on Steeze stock?

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22. Consider the following investment opportunity.

Assume the annual figures are unchanged for the expected life of the investment. What is the
rate of return on this investment? Assuming the investor wants to earn at least 12 percent, is
this investment an attractive one?

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23. A company is considering two alternative methods of producing a new product. The
relevant data concerning the alternatives are presented below.

At the end of the useful life of whatever equipment is chosen the product will be discontinued.
The company's tax rate is 50 percent and its cost of capital is 10 percent.

a. Calculate the net present value of each alternative.

b. Calculate the benefit cost ratio for each alternative.
c. Calculate the internal rate of return for each alternative.
d. If the company is not under capital rationing, which alternative should be chosen? Why?

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24. Given the following information about a possible average-risk, new product investment,
calculate the investment's net present value.

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Chapter 07 - Discounted Cash Flow Techniques

25. Your brother, age 40, is the regional manager at an office supply company. He thinks he
might want to leave his job to go back to school for an MBA. He expects that his current job,
if he were to stay at it, would pay him a real income stream of $75,000 per year until
retirement at age 65. If he goes back to school, he would forego two years of income, but his
real income after graduation would be $110,000 per year until retirement at age 65. He has
been accepted to an MBA program that costs a real $22,000 per year. If his real opportunity
cost is 8 percent, would leaving his job to get an MBA be a smart financial decision?

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Chapter 07 Discounted Cash Flow Techniques Answer Key

Multiple Choice Questions

1. Which of the following is not an important step in the financial evaluation of an investment
opportunity?
A. Calculate a figure of merit for the investment.
B. Estimate the accounting rate of return for the investment.
C. Estimate the relevant cash flows.
D. Compare the figure of merit to an acceptance criterion.
E. All of the above are important steps.

Difficulty: 1 Easy

2. Which of the following figures of merit might not use all possible cash flows in its
calculations?

I. Payback period
II. Internal rate of return
III. Net present value (NPV)
IV. Accounting rate of return
A. III only
B. I & III only
C. II & III only
D. I & IV only
E. III & IV only
F. I, II, III, and IV

Difficulty: 2 Medium

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Chapter 07 - Discounted Cash Flow Techniques

3. Which of the following figures of merit does not directly take into consideration the time
value of money?

I. Payback period
II. Internal rate of return
III. Net present value (NPV)
IV. Accounting rate of return
A. IV only
B. I & III only
C. II & III only
D. I & II only
E. I & IV only
F. I, II, III, and IV

Difficulty: 2 Medium

4. Ian is going to receive $20,000 six years from now. Sunny is going to receive $20,000 nine
years from now. Which one of the following statements is correct if both Ian and Sunny apply
a 7 percent discount rate to these amounts?
A. The present values of Ian and Sunny's monies are equal.
B. In future dollars, Sunny's money is worth more than Ian's money.
C. In today's dollars, Ian's money is worth more than Sunny's.
D. Twenty years from now, the value of Ian's money will be equal to the value of Sunny's
money.
E. Sunny's money is worth more than Ian's money given the 7 percent discount rate.
F. None of the above.

Difficulty: 2 Medium

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Chapter 07 - Discounted Cash Flow Techniques

5. You plan to buy a new Mercedes four years from now. Today, a comparable car costs
$82,500. You expect the price of the car to increase by an average of 4.8 percent per year over
the next four years. How much will your dream car cost by the time you are ready to buy it?
A. $98,340.00
B. $98,666.67
C. $99,517.41
D. $99,818.02
E. $100,023.16
F. None of the above.

Future value = $82,500  (1 + .048)4 = $99,517.41

Difficulty: 1 Easy

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6. Your grandmother invested a lump sum 26 years ago at 4.25 percent interest. Today, she
gave you the proceeds of that investment which totaled $51,480.79. How much did she
originally invest?
A. $15,929.47
B. $16,500.00
C. $17,444.86
D. $17,500.00
E. $17,999.45
F. None of the above.

Present value = $51,480.79  [1/(1 + .0425)26] = $17,444.86

Difficulty: 1 Easy

7. Naomi plans on saving $3,000 a year and expects to earn an annual rate of 10.25 percent.
How much will she have in her account at the end of 45 years?
A. $1,806,429
B. $1,838,369
C. $2,211,407
D. $2,333,572
E. $2,508,316
F. None of the above.

Difficulty: 1 Easy

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Chapter 07 - Discounted Cash Flow Techniques

8. You are the beneficiary of a life insurance policy. The insurance company informs you that
you have two options for receiving the insurance proceeds. You can receive a lump sum of
$200,000 today or receive payments of $1,400 a month for 20 years. You can earn a 6 percent
annual rate on your money, compounded monthly. Which option should you take and why?
A. You should accept the monthly payments because they are worth $209,414 to you.
B. You should accept the $200,000 lump sum because the monthly payments are only worth
$16,057 to you today.
C. You should accept the monthly payments because they are worth $336,000 to you.
D. You should accept the $200,000 lump sum because the monthly payments are only worth
$189,311 to you today.
E. You should accept the $200,000 lump sum because the monthly payments are only worth
$195,413 to you today.
F. None of the above.

The number of monthly periods = 20 x 12 = 240; the monthly interest rate = 6%/12 = 0.5%.

Difficulty: 1 Easy

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9. Your brother will borrow $17,800 to buy a car. The terms of the loan call for monthly
payments for 5 years at an 8.6 percent annual interest rate, compounded monthly. What is the
amount of each payment?
A. $287.71
B. $296.67
C. $301.12
D. $342.76
E. $366.05
F. None of the above.

The number of monthly periods = 5 x 12 = 60; the monthly interest rate = 8.6%/12 =
0.71667%

Difficulty: 1 Easy

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10. EAC Nutrition offers a 9.5 percent coupon bond with annual payments, maturing 11 years
from today. Your required return is 11.2 percent. What price are you willing to pay for this
bond if the face (or par) value is $1,000?
A. $895.43
B. $896.67
C. $941.20
D. $946.18
E. $953.30
F. None of the above.

Price = present value of coupons and face value. The coupon payments = (.095  1000) = $95
per year.

Difficulty: 1 Easy

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11. A project will produce after-tax operating cash inflows of $3,200 a year for 5 years. The
after-tax salvage value of the project is expected to be $2,500 in year 5. The project's initial
cost is $9,500. What is the net present value of this project if the required rate of return is 16
percent?
A. -$311.02
B. $2,168.02
C. $4,650.11
D. $9,188.98
E. $21,168.02
F. None of the above.

Solve for the PV of the cash inflows, and then subtract the initial investment:

NPV = 11668.02 - 9,500 = $2,168.02

Difficulty: 1 Easy

12. Which of the following should be included in the analysis of a new product?

I. Money already spent for research and development of the new product
II. Reduction in sales for a current product once the new product is introduced
III. Increase in working capital needed to finance sales of the new product
IV. Interest expense on the loan used to finance the new product launch
A. II and III only
B. II and IV only
C. I, II, and III only
D. II, III, and IV only
E. I, II, III, and IV
F. None of the above.

Difficulty: 2 Medium

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Chapter 07 - Discounted Cash Flow Techniques

13. Pro forma free cash flows for a proposed project should:

I. exclude the cost of employing existing assets that could be sold anyway.
II. exclude interest expense.
III. include the depreciation tax shield related to the project.
IV. exclude any required increase in operating current assets.
A. I and II only
B. II and III only
C. II and IV only
D. I, III, and IV only
E. I, II, III, and IV
F. None of the above.

Difficulty: 2 Medium

14. Which of the following statements related to the internal rate of return (IRR) are correct?

I. The IRR is the discount rate at which an investment's NPV equals zero.
II. An investment should be undertaken if the discount rate exceeds the IRR.
III. The IRR tends to be used more than net present value simply because its results are easier
to comprehend.
IV. The IRR is the best tool available for deciding between mutually exclusive investments.
A. I and II only
B. I and III only
C. II and III only
D. I, II, and IV only
E. I, II, III, and IV
F. None of the above.

Difficulty: 2 Medium

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15. You plan to pay $50 for a share of preferred stock that pays a $2.40 dividend per year
forever. What annual rate of return will you realize?
A. 0.48 percent
B. 2.40 percent
C. 4.80 percent
D. 5.10 percent
E. 20.83 percent
F. None of the above.

r = A/P = $2.40/$50 = 4.80%

Difficulty: 1 Easy

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16. Sol's Sporting Goods is expanding, and as a result expects additional operating cash flows
of $26,000 a year for 4 years. This expansion requires $39,000 in new fixed assets. These
assets will be worthless at the end of the project. In addition, the project requires an additional
$3,000 of net working capital throughout the life of the project; Sol expects to recover this
amount at the end of the project. What is the net present value of this expansion project at a 16
percent required rate of return?
A. $18,477.29
B. $21,033.33
C. $28,288.70
D. $29,416.08
E. $32,409.57
F. None of the above.

The initial investment consists of the fixed assets and incremental working capital: $39,000 +
$3000 = $42,000. The working capital amount is recovered at the end of year 4. Solve for the
PV of the cash inflows, and then subtract the initial investment:

NPV = 74,409.57 - 42,000 = $32,409.57

Difficulty: 1 Easy

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17. What is the benefit-cost ratio for an investment with the following cash flows at a 14.5
percent required return?

A. 0.94
B. 0.98
C. 1.02
D. 1.06
E. 1.11
F. None of the above.

Difficulty: 1 Easy

18. When making a capital budgeting decision, which of the following is/are NOT relevant?

I. The size of a cash flow.

II. The risk of a cash flow.
III. The accounting earnings from a cash flow.
IV. The timing of a cash flow.
A. I only
B. II only
C. III only
D. II and III only
E. III and IV only
F. They are all relevant.

Difficulty: 2 Medium

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Short Answer Questions

19. An investment costing $100,000 promises an after-tax cash flow of $36,000 per year for 6
years.

a. Find the investment's accounting rate of return and its payback period.
b. Find the investment's net present value at a 15 percent discount rate.
c. Find the investment's benefit-cost ratio (profitability index) at a 15 percent discount rate.
d. Find the investment's internal rate of return.
e. Assuming the required rate of return on the investment is 15 percent, which of the above
figures of merit indicate the investment is attractive? Which indicate it is unattractive?

a. The accounting rate of return = 36/100 = 36%

The payback period = 100/36 = 2.778 years
b. NPV = - 100 + 36(3.784) = $36,224
c. BCR, or PI = 36(3.784)/100 = 1.3622
d. NPV = 0 = - 100 + 36(PVAF, r%, 6 yrs); (PVAF, r%, 6 yrs) = 2.7778, where PVAF is a
present value annuity factor from Appendix B. Consulting Appendix B and interpolating, or
using a financial calculator (inputs: 36 = PMT, - 100 = PV, 6 = N, I =?), IRR = 27.698%.
e. The NPV, PI, and IRR all indicate unambiguously that the investment is worthwhile. The
accounting rate of return suggests the same, but is not a reliable indicator of investment value,
nor is it comparable to the 15 percent required rate of return on the investment. Because there
is no reliable way to transform a 15 percent required rate of return into a maximum acceptable
payback period, it is not clear whether a 2.778 year payback period is short enough.

Difficulty: 2 Medium

20. At $1,000 par value, 10 percent coupon bond matures in 20 years. If the price of the bond
is $1,196.80, what is the yield to maturity on the bond? Assume interest is paid annually.

NPV = 0 = 100(PVAF, r%, 20yrs) + 1,000(PVF, r%, 20th yr.) - 1,196.80. Unless we use a
financial calculator or spreadsheet program, we must use trial-and-error to search for the
discount rate which makes the NPV zero. Because the price of the bond exceeds its maturity
value, we know the yield to maturity must be less than the coupon rate. Let's try 8 percent.
0 = 100(9.818) + 1,000(0.215) - 1,196.8 = 0. Therefore, the yield to maturity = 8 percent.
Alternatively, the calculator inputs are: - 1196.8 = PV, 100 = PMT, 1000 = FV, 20 = N, I =?
and the output indicates a yield = 7.996%.

Difficulty: 2 Medium

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21. Ten years ago you invested $1,000 for 10 shares of Steeze, Inc. common stock. You sold
the shares recently for $2,000. While you owned the stock it paid $10.08 per share in annual
dividends. What was your rate of return on Steeze stock?

Total dividends per year = 10 shares x $10.08 per share = $100.80.

NPV = - 1,000 + 2,000(PVF, r%, 10th yr) + 100.8(PVAF, r%, 10 yrs) = 0.
Using trial-and-error, let's try 15%: - 1,000 + 2,000(0.247) + 100.8(5.019) = - .08. Therefore,
IRR equals approximately 15 percent.
Alternatively, the calculator inputs are: - 1000 = PV, 100.8 = PMT, 2000 = FV, 10 = N, I =?
and the output indicates an annual return = 15.004%.

Difficulty: 2 Medium

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22. Consider the following investment opportunity.

Assume the annual figures are unchanged for the expected life of the investment. What is the
rate of return on this investment? Assuming the investor wants to earn at least 12 percent, is
this investment an attractive one?

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Chapter 07 - Discounted Cash Flow Techniques

NPV = - 850,000 + 206,500(PVAF, r%, 20yrs) + 40,000(PVF, r%, 20th yr) = 0.

Using trial-and-error, let's try 20%:
NPV = - 850,000 + 206,500(4.870) + 40,000(.026) = + 156,695. Interpolating, IRR = about
24.1 percent.
Using a financial calculator or Excel, IRR = 23.979%. The investment is clearly attractive at a
hurdle rate of 12%. Alternatively, calculate the NPV at a discount rate of 12%; the NPV is
positive and therefore the investment opportunity is an attractive one.

Difficulty: 2 Medium

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23. A company is considering two alternative methods of producing a new product. The
relevant data concerning the alternatives are presented below.

At the end of the useful life of whatever equipment is chosen the product will be discontinued.
The company's tax rate is 50 percent and its cost of capital is 10 percent.

a. Calculate the net present value of each alternative.

b. Calculate the benefit cost ratio for each alternative.
c. Calculate the internal rate of return for each alternative.
d. If the company is not under capital rationing, which alternative should be chosen? Why?

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a.

NPVI = 23(3.17) - 64 = $9,000

NPVII = 34(4.355) - 120 = $28,000.
b. BCRI = 23(3.17)/64 = 1.14; BCRII = 34(4.355)/120 = 1.23
c. IRRI => NPV = 23(PVAF, r%, 4 yrs) - 64 = 0. PVAF, r%, 4 yrs. = 64/23 = 2.782.
Consulting Appendix B for 4 yrs, the PVAF for 16% = 2.798, hence, IRR = about 16 percent.
Using a financial calculator or Excel, IRR = 16.3%.
IRRII => NPV = 34(PVAF, r%, 6 yrs.) - 120 = 0. PVAF, r%, 6 yrs. = 120/34 = 3.529.
Consulting Appendix B for 6 years, the PVAF for 17% is 3.589 and the value for 16% is
3.685. Interpolating, IRR is about equal to 17.7 percent. Using a financial calculator or Excel,
IRR = 17.6%
d. The company should choose II because II has the higher NPV and NPV is a direct measure
of increase in shareholder wealth.

Difficulty: 3 Hard

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24. Given the following information about a possible average-risk, new product investment,
calculate the investment's net present value.

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Chapter 07 - Discounted Cash Flow Techniques

Ending inventory = production cost/4 = $27,500

Accounts receivable = 45(200,000/365) = 25,000

Cash Flows:

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NPV at 8% cost of capital = $77,658

Difficulty: 3 Hard

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25. Your brother, age 40, is the regional manager at an office supply company. He thinks he
might want to leave his job to go back to school for an MBA. He expects that his current job,
if he were to stay at it, would pay him a real income stream of $75,000 per year until
retirement at age 65. If he goes back to school, he would forego two years of income, but his
real income after graduation would be $110,000 per year until retirement at age 65. He has
been accepted to an MBA program that costs a real $22,000 per year. If his real opportunity
cost is 8 percent, would leaving his job to get an MBA be a smart financial decision?

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Chapter 07 - Discounted Cash Flow Techniques

To begin, calculate the present value of the real income stream from his current position. This
results in a present value of $800,608.21.

For school, the present value of your brother's real income stream is the present value of the
23-year real income from the new job, discounted back 2 years at the real discount rate, minus
the present value of the cost of the MBA program.

The value of the MBA real income stream, discounted back 2 years, is $1,022,523.82.

The present value of the cost of the MBA program is $39,231.82.

The net present value of your brother's MBA real income stream is the difference, or

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Chapter 07 - Discounted Cash Flow Techniques

$1,022,523.82 - $39,231.82 = $983,292. This is greater than the value of his current income
stream, so the correct financial decision is to return to school for an MBA.

Difficulty: 3 Hard

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