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Capital Budgeting Simulated Exam Answer Key

A corporation sold an asset for $12,000 that originally cost $10,000 and had $6,000 of depreciation. The question asks how much after-tax cash the corporation will receive from the sale. A machine that cost $50,000 and was fully depreciated was sold for $10,000 and the proceeds were used as a down payment on a new $75,000 machine. The question asks for the out-of-pocket cost of the new machine assuming a 40% tax rate. A project requires an initial $8 million investment in equipment. The question estimates the total cash investment required considering expected sales increases, cash investment in current assets, and accounts payable

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0% found this document useful (0 votes)

2K views110 pages

Capital Budgeting Simulated Exam Answer Key

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Sarah Balisacan

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i

. A corporation with a taxable income of $200,000 and a 40 percent tax rate is considering the sale of an asset.
The original cost of the asset is $10,000, with $6,000 of its depreciated. How much total after-tax cash will be
produced from the sale of the asset for $12,000?
a. $10,400 d. $(3,200)
b. $12,000 e. $8,800
c. $11,200 H&M
ii
. A machine that cost $50,000 and is fully depreciated is sold for $10,000. The $10,000 is then used as
a down payment on the purchase of a new machine costing $75,000. Assuming a 40% tax rate, the
out-of-pocket cost of the new machine is:
A. $75,000 C. $65,000

B. $71,000 D. $69,000 C&U

iii
. A machine that cost $50,000 and is fully depreciated is allowed as a $10,000 trade-in on a machine
costing $75,000. Assuming a 40% tax rate, the out-of-pocket cost of the new machine is:
A. $75,000 C. $65,000

B. $71,000 D. $69,000 C &

iv
. Kline Corporation is expanding its plant, which requires an investment of $8 million in new equipment. Kline's
sales are expected to increase by $6 million per year as a result of the expansion. Cash investment in current
assets averages 30% of sales, and accounts payable and other current liabilities are 10% of sales. What is the
estimated total cash investment for this expansion? (E)

A. $6.8 million. C. $9.2 million.

B. $8.6 million. D. $9.8 million. Gleim

v
. Assume that the interest rate is greater than zero. Which of the following cash-inflow streams should you prefer?
Gleim

Year 1 Year 2 Year 3 Year 4

A. $400 $300 $200 $100

B. $100 $200 $300 $400

C. $250 $250 $250 $250

D. Any of these, since they each sum to $1,000.

vi
. A company considers a project that will generate cash sales of $50,000 per year. Fixed costs will be $10,000 per
year, variable costs will be 40% of sales, and depreciation of the equipment in the project will be $5,000 per
year. Taxes are 40%. The expected annual cash flow to the company resulting from the project is

A. $15,000 C. $19,000

B. $9,000 D. $14,000 CIA 1193 IV-50

vii
. Garfield Inc. is considering a 10-year capital investment project with forecasted revenues of $40,000 per year
and forecasted cash operating expenses of $29,000 per year. The initial cost of the equipment for the project is
$23,000, and Garfield expects to sell the equipment for $9,000 at the end of the tenth year. The equipment will
be depreciated over 7 years. The project requires a working capital investment of $7,000 at its inception and
another $5,000 at the end of year 5. Assuming a 40% marginal tax rate, the expected net cash flow from the
project in the tenth year is (D)

a. $32,000 c. $20,000

b. $24,000 d. $11,000 CMA 1292 4-10

viii
. Metrejean Industries is analyzing a capital investment proposal for new equipment to produce a product over the
next 8 years. At the end of 8 years, the equipment must be removed from the plant and will have a net book
value of $0, a tax basis of $150,000, a cost to remove of $80,000, and scrap salvage value of $20,000.
Metrejean’s effective tax rate is 40%. What is the appropriate “end-of-life” cash flow related to these items that
should be used in the analysis? (D)

a. $90,000 c. $24,000

b. $54,000 d. $(36,000) Gleim

ix
.
If the tax rate is 40% and a company has $400,000 of income, a depreciation deduction of $80,000 would result
in a tax savings of
a. $52,800 c. $32,000
b. $48,000 d. $27,200
x
. At the end of the next four years, a new machine is expected to generate net cash flows of $8,000,
$12,000, $10,000, and $15,000, respectively. What are the cash flows worth today if a 3% interest
rate properly reflects the time value of money in this situation? (E)
A. $41,556. C. $32,400.

B. $47,700. D. $38,100. S, S & T

xi
. A project requires an investment of $80,000 in equipment. Annual cash inflows of $16,000 are expected to occur
for the next 8 years. No salvage value is expected. The company uses the straight-line method of depreciation
with no mid-year convention. Ignore income taxes.

The accounting rate of return on original investment for the project is (M)

a. 6.25% c. 16.00%

b. 7.50% d. 20.00%
xii
. The Mutya ng Pasig Company, a calendar company, purchased a new machine for P280,000 on January 1.
Depreciation for tax purposes will be P35,000 annually for eight years. The accounting (book value) rate of
return (ARR) is expected to be 20% on the initial increase in required investment. On the assumption of a
uniform cash inflow, this investment is expected to provide annual cash flow from operations, before 30 percent
income taxes, of (M)
A. P80,000 C. P115,000
B. P91,000 D. P175,000
xiii
. Whatney Company is considering the acquisition of a new, more efficient press. The cost of the press is
$360,000, and the press has an estimated 6-year life with zero salvage value. Whatney uses straight-line
depreciation for both financial reporting and income tax reporting purposes and has a 40% corporate income tax
rate. In evaluating equipment acquisition of this type, Whatney uses a goal of a 4-year payback period. To meet
Whatney’s desired payback period, the press must produce a minimum annual before-tax operating cash
savings of (M)

a. $90,000 c. $114,000

b. $110,000 d. $150,000 CMA 1296 4-13

xiv
. The net initial investment for a piece of construction equipment is $1,000,000. Annual cash inflows are expected
to increase by $200,000 per year. The equipment has an 8-year useful life. What is the payback period? (E)
a. 8.00 years c. 6.00 years
b. 7.00 years d. 5.00 years Horngren
xv
. Haig Aircraft is considering a project which has an up-front cost paid today at t = 0. The project will generate
positive cash flows of $60,000 a year at the end of each of the next five years. The project’s NPV is $75,000
and the company’s WACC is 10 percent. What is the project’s simple, regular payback? (M)
a. 3.22 years d. 2.35 years
b. 1.56 years e. 4.16 years
c. 2.54 years Brigham
xvi
. If an initial investment outlay is $60,000 and the cash flows projected are $15,000, $20,000,
$25,000, and $10,000 in each of the first four years, respectively, the payback period in years would
be: (E)
A. 3.3 D. 4.0

B. 3.0 E. 5.0

C. 2.5 C&U
xvii
. Michigan Mattress Company is considering the purchase of land and the construction of a new plant. The land,
which would be bought immediately (at t = 0), has a cost of $100,000 and the building, which would be erected
at the end of the first year (t = 1), would cost $500,000. It is estimated that the firm’s after-tax cash flow will be
increased by $100,000 starting at the end of the second year, and that this incremental flow would increase at a
10 percent rate annually over the next 10 years. What is the approximate payback period? (M)

a. 2 years d. 8 years

b. 4 years e. 10 years

c. 6 years Brigham
xviii
. Monck Management Services is considering an investment of $30,000. Data related to the investment are as
follows:
Cash Inflows
Year
1 $10,000

2 12,000

3 15,000

4 20,000

5 10,000

Cost of capital is 18 percent.

What is the payback period in years approximated to two decimal points assuming no taxes are paid?

a. 3.00 d. 2.22

b. 2.00 e. 5.00

c. 2.53 H&M
xix
. For $45,000, Harmon Company purchased a new machine with an estimated useful life of five years
with no salvage value. The machine is expected to produce cash flow from operations, net of
income taxes, as follows:

1st year $ 9,000

2d year 12,000

3d year 15,000

4th year 9,000

5th year 8,000

Harmon will use the sum-of-the-years-digits' method to depreciate the new machine as follows:

1st year $15,000

2d year 12,000

3d year 9,000

4th year 6,000

5th year 3,000

What is the payback period? (E

A. 3 years C. 5 years

B. 4 years D. 2 years AICPA adapted

D. 4.81 years. CMA 0691 4-16
xx
. Jordan Company is considering the purchase of a new machine for $200,000. The machine generates annual
revenues of $125,000 and annual expenses of $75,000 which includes $15,000 of depreciation. What is the
payback period in years on the machine approximated to one decimal point?

a. 1.6 d. 1.7

b. 3.1 e. 2.1

c. 4.0
xxi
. Womark Company purchased a new machine on January 1 of this year for $90,000, with an estimated useful life
of 5 years and a salvage value of $10,000. The machine will be depreciated using the straight-line method. The
machine is expected to produce cash flow from operations, net of income taxes, of $36,000 a year in each of the
next 5 years. The new machine’s salvage value is $20,000 in years 1 and 2, and $15,0000 in years 3 and 4.
What will be the bailout period (rounded) for the new machine? (E)

a. 1.4 years. c. 1.9 years.

b. 2.2 years. d. 3.4 years. AICPA 0582 I-36

xxii
. A project has the following cash flows:

Year Project Cash Flow

0 -$3,000

1 1,000

2 1,000

3 1,000

4 1,000

Its cost of capital is 10 percent. What is the project’s discounted payback period? (E)

a. 3.00 years d. 3.75 years

b. 3.30 years e. 4.75 years

c. 3.52 years Brigham

xxiii
. Polk Products is considering an investment project with the following cash flows:

Year Project Cash Flow

0 -$100,000
1 40,000

2 90,000

3 30,000

4 60,000

The company has a 10 percent cost of capital. What is the project’s discounted payback? (M)
a. 1.67 years d. 2.49 years

b. 1.86 years e. 2.67 years

c. 2.11 years Brigham

xxiv
. Shirt Company wants to purchase a new cutting machine for its sewing plant. The investment is expected to
generate annual cash inflows of $300,000. The required rate of return is 12% and the current machine is
expected to last for four years. What is the maximum dollar amount Shirt Company would be willing to spend for
the machine, assuming its life is also four years? Income taxes are not considered. (M)
a. $507,000 c. $791,740
b. $720,600 d. $911,100
xxv
. Pole Co. is investing in a machine with a 3-year life. The machine is expected to reduce annual cash operating
costs by $30,000 in each of the first 2 years and by $20,000 in year 3. Present values of an annuity of $1 at
14% are:

Period 1 2 3

Factor 0.88 1.65 2.32

Using a 14% cost of capital, what is the present value of these future savings? (E)
a. $59,600 c. $62,900

b. $60,800 d. $69,500
xxvi
. Shannon Industries is considering a project which has the following cash flows:

Year Project Cash Flow

0 ?

1 $2,000

2 3,000

3 3,000

4 1,500

The project has a payback of 2.5 years. The firm’s cost of capital is 12 percent. What is the project’s net
present value NPV? (M)
a. $ 577.68 d. $2,761.32

b. $ 765.91 e. $3,765.91

c. $1,049.80 Brigham
xxvii
. You are considering the purchase of an investment that would pay you $5,000 per year for Years 1-5, $3,000 per
year for Years 6-8, and $2,000 per year for Years 9 and 10. If you require a 14 percent rate of return, and the
cash flows occur at the end of each year, then how much should you be willing to pay for this investment? (M)

a. $15,819.27 d. $38,000.00

b. $21,937.26 e. $52,815.71

c. $32,415.85 Brigham
xxviii
. A capital investment project requires an investment of $50,000 and has an expected life of 4 years. Annual cash
flows at the end of each year are expected to be as follows:
Amount
Year
1 $20,000

2 24,000

3 38,000

4 28,000

Ignoring income taxes, the net present value of the project using a 6% discount rate is
a. $44,316 c. $34,148
b. $12,396 d. $(14,148) H&M
xxix
. Hawkeye Cleaners has been considering the purchase of an industrial dry-cleaning machine. The existing
machine is operable for three more years and will have a zero disposal price. If the machine is disposed of now,
it may be sold for $60,000. The new machine will cost $200,000 and an additional cash investment in working
capital of $60,000 will be required. The new machine will reduce the average amount of time required to wash
clothing and will decrease labor costs. The investment is expected to net $50,000 in additional cash inflows
during the year of acquisition and $150,000 each additional year of use. The new machine has a three-year life,
and zero disposal value. These cash flows will generally occur throughout the year and are recognized at the
end of each year. Income taxes are not considered in this problem. The working capital investment will not be
recovered at the end of the asset's life.
What is the net present value of the investment, assuming the required rate of return is 10%? Would the
company want to purchase the new machine? (M)
a. $82,000; yes c. $(50,000); yes
b. $50,000; no d. $(82,000); no Horngren
xxx
. Wet and Wild Water Company drills small commercial water wells. The company is in the process of analyzing
the purchase of a new drill. Information on the proposal is provided below.
Initial investment:
Asset $160,000
Working capital $ 32,000
Operations (per year for four years):
Cash receipts $160,000
Cash expenditures $ 88,000
Disinvestment:
Salvage value of drill (existing) $ 16,000
Discount rate 20%
What is the net present value of the investment? Assume there is no recovery of working capital. (M)
a. $(62,140) c. $42,362
b. $10,336 d. $186,336 Horngren

xxxi
. R. D. Inc. purchased a machine for $240,000. The machine has a useful life of six years, no salvage
value, and straight-line depreciation is to be used. The machine is expected to generate cash flows
from operations, net of income tax, of $70,000 in each of the six years. R. D. Inc's cost of capital is
12%. The net present value is:
A. $180,000 D. $121,680

B. $35,490 E. $123,330

C. $47,770 C&U
xxxii
. Drillers Inc. is evaluating a project to produce a high-tech deep-sea oil exploration device. The investment
required is $80 million for a plant with a capacity of 15,000 units a year for 5 years. The device will be sold for a
price of $12,000 per unit. Sales are expected to be 12,000 units per year. The variable cost is $7,000 and fixed
costs, excluding depreciation, are $25 million per year. Assume Drillers employs straight-line depreciation on all
depreciable assets, and assume that they are taxed at a rate of 36%. If the required rate of return is 12%, what
is the approximate NPV of the project? (M)

A. $17,225,000 C. $26,780,000

B. $21,511,000 D. $56,117,000 Gleim

xxxiii
. The following forecasts have been prepared for a new investment by Oxford Industries of $20 million with an 8-
year life:

Pessimistic Expected Optimistic

Market size 60,000 90,000 140,000

Market share, % 25 30 35

Unit price $750 $800 $875

Unit variable cost $500 $400 $350

Fixed cost, millions $7 $4 $3.5

Assume that Oxford employs straight-line depreciation, and that they are taxed at 35%. Assuming an opportunity
cost of capital of 14%, what is the NPV of this project, based on expected outcomes?

A. $2,626,415 C. $6,722,109
B. $4,563,505 D. $8,055,722 Gleim
xxxiv
. For the next 2 years, a lease is estimated to have an operating net cash inflow of $7,500 per annum, before
adjusting for $5,000 per annum tax basis lease amortization, and a 40% tax rate. The present value of an
ordinary annuity of $1 per year at 10% for 2 years is 1.74. What is the lease’s after-tax present value using a
10% discount factor? (E)

a. $2,610 c. $9,570

b. $4,350 d. $11,310 Gleim, RPCPA 1001

xxxv
. Mesa Company is considering an investment to open a new banana processing division. The project in question
would entail an initial investment of $45,000, and as a result of the project cash inflows of $20,000 can be
expected in each of the next 3 years. The hurdle rate is 10%. What is the profitability index for the project? (E)

A. 1.0784 C. 1.1379

B. 1.1053 D. 1.1771 Gleim

xxxvi
. A firm is considering a project with annual cash flows of $40,000. The project would have a 10-year life, and the
company uses a discount rate of 8%. Ignoring income taxes, what is the maximum amount the company could
invest in the project and the project still be acceptable (rounded)?
a. $400,000 c. $203,210
b. $268,400 d. $363,604 H&M

xxxvii
. Conte Inc. invested in a machine with a useful life of six years and no salvage value. The machine is
expected to produce annual cash flows from operations, net of income tax, of $2,000. If the
estimated internal rate of return is 10%, the amount of the original investment was: (M)
A. $9,000 D. $5,640

B. $11,280 E. $8,710

C. $12,000 C&U
xxxviii
. Kern Co. is planning to invest in a 2-year project that is expected to yield cash flows from operations, net of
income taxes, of $50,000 in the first year and $80,000 in the second year. Kern requires an internal rate of
return of 15%. The present value of $1 for one period at 15% is 0.870 and for two periods at 15% is 0.756. The
future value of $1 for one period at 15% is 1.150 and for two periods at 15% is 1.323. The maximum that Kern
should invest immediately is (E)

a. $81,670 c. $130,000

b. $103,980 d. $163,340 AICPA 1189 II-36

xxxix
. Payback Company is considering the purchase of a copier machine for P42,825. The copier
machine will be expected to be economically productive for 4 years. The salvage value at the end of 4
years is negligible. The machine is expected to provide 15% internal rate of return. The company is
subject to 40% income tax rate. The present value of an ordinary annuity of 1 for 4 periods is 2.85498.
In order to realize the IRR of 15%, how much is the estimated before-tax cash inflow to be provided by
the machine?(M)
A. P17,860 C. P25,000
B. P15,000 D. P35,700
xl
. Para Co. is reviewing the following data relating to an energy saving investment proposal:

Cost $50,000

Residual value at the end of 5 years 10,000

Present value of an annuity of 1 at 12% for 5 years 3.60

Present value of 1 due in 5 years at 12% 0.57

What would be the annual savings needed to make the investment realize a 12% yield?(M)

a. $8,189 c. $12,306

b. $11,111 d. $13,889
xli
. What is the approximate IRR for a project that costs $50,000 and provides cash inflows of $20,000 for 3 years?

A. 10% C. 22%

B. 12% D. 27% Gleim

xlii
. Which of the following statements is most likely correct for a project costing $50,000 and returning $14,000 per
year for 5 years?

A. NPV = $36,274. C. IRR = 1.4%.

B. NPV = $20,000. D. IRR is greater than 10%. Gleim

xliii
. A firm is considering a project requiring an investment of $100,000. The project would generate annual cash
inflows of $27,739 per year for the next 5 years. The company uses the straight-line method of depreciation with
no mid-year convention. Ignore income taxes. The approximate internal rate of return for the project is
a. 9% d. 16%
b. 10% e. 28%
c. 12% H&M
xliv
. Foster Company is considering the purchase of a new machine for $38,000. The machine would generate a net
cash inflow of $11,607 per year for five years. At the end of five years, the machine would have no salvage
value. The company’s cost of capital is 12 percent. The company uses straight-line depreciation with no mid-
year convention.
What is the internal rate of return for the machine rounded to the nearest percent, assuming no taxes are paid?
a. 12% c. 14%
b. 18% d. 16% H&M
xlv
. Soda Manufacturing Company provides vending machines for soft-drink manufacturers. The company has been
investigating a new piece of machinery for its production department. The old equipment has a remaining life of
three years and the new equipment has a value of $52,650 with a three-year life. The expected additional cash
inflows are $25,000 per year. What is the internal rate of return? (E)
a. 20% c. 10%
b. 16% d. 8% Horngren

xlvi
. Whitney Crane Inc. has the following independent investment opportunities for the coming year:

Project Cost Annual Cash Inflows Life (Years) IRR

A $10,000 $11,800 1

B 5,000 3,075 2 15

C 12,000 5,696 3

D 3,000 1,009 4 13

The IRRs for Projects A and C, respectively, are:

a. 16% and 14% d. 18% and 13%

b. 18% and 10% e. 16% and 13%

c. 18% and 20% Brigham

xlvii
. The capital budgeting director of Sparrow Corporation is evaluating a project which costs $200,000, is expected
to last for 10 years and produce after-tax cash flows, including depreciation, of $44,503 per year. If the firm’s
cost of capital is 14 percent and its tax rate is 40 percent, what is the project’s IRR? (E)

a. 8% d. -5%

b. 14% e. 12%

c. 18% Brigham
xlviii
. Two fellow financial analysts are evaluating a project with the following net cash flows:

Year Cash Flow

0 -$ 10,000

1 100,000

2 -100,000

One analyst says that the project has an IRR of between 12 and 13 percent. The other analyst calculates an
IRR of just under 800 percent, but fears his calculator’s battery is low and may have caused an error. You agree
to settle the dispute by analyzing the project cash flows. Which statement best describes the IRR for this
project? (D)

a. There is a single IRR of approximately 12.7 percent.

b. This project has no IRR, because the NPV profile does not cross the X axis.

c. There are multiple IRRs of approximately 12.7 percent and 787 percent.

d. This project has two imaginary IRRs.

e. There are an infinite number of IRRs between 12.5 percent and 790 percent that can define the IRR for this
project. Brigham
xlix
. Alyeska Salmon Inc., a large salmon canning firm operating out of Valdez, Alaska, has a new automated
production line project it is considering. The project has a cost of $275,000 and is expected to provide after-tax
annual cash flows of $73,306 for eight years. The firm’s management is uncomfortable with the IRR
reinvestment assumption and prefers the modified IRR approach. You have calculated a cost of capital for the
firm of 12 percent. What is the project’s MIRR? (M)

a. 15.0% d. 16.0%

b. 14.0% e. 17.0%

c. 12.0% Brigham
l
. You just passed the CPA licensure examination and took your oath. As you started your practice,
Kon Fuse, Inc. came to you for help in establishing a minimum desired rate of return to be used in
the evaluation of a capital project with a five year life. The following data were provided: (D)

Inflation rate for the past 5 years 13%

Expected inflation rate for the next five years 9%

“Risk-free” element 5%

“Risk” premium demanded for the project 7%

You will advice the client to consider a minimum desired rate of return of

a. 20% c. 16%

b. 21% d. 25% RPCPA 0596

li
. Suzie owns a computer reselling business and is expanding her business. Suzie is presented with one proposal,
Proposal A, such that the estimated investment for the expansion project is $85,000, and it is expected to
produce cash flows after taxes of $25,000 for each of the next 6 years. An alternate proposal, Proposal B,
involves an investment of $32,000 and after-tax cash flows of $10,000 for each of the next 6 years. The cost of
capital that would make Suzie indifferent between these two proposals lies between

a. 10% and 12% c. 16% and 18%

b. 14% and 16% d. 18% and 20% Gleim
lii
. The U.S. Postal Service is looking for a new machine to help sort the mail. Two companies have

submitted bids to Cliff Kraven, the postal inspector responsible for choosing a machine. A cash flow

analysis of the two machines indicates the following:

Year Machine A Machine B

0 -$30,000 -$30,000

1 0 13,000

2 0 13,000

3 0 13,000

4 60,000 13,000

If the cost of capital for the Postal Service is 8%, which of the two mail sorters should Cliff choose and why? (M)

A. Machine A, because NPVA > NPVB, by $1,044.

B. Machine B, because NPVA < NPVB, by $22,000.

C. Machine A, because NPVA > NPVB, by $8,000.

D. Machine B, because IRRA < IRRB. Gleim

liii
. Union Electric Company must clean up the water released from its generating plant. The company's cost of
capital is 11 percent for average projects, and that rate is normally adjusted up or down by 2 percentage points
for high- and low-risk projects. Clean-Up Plan A, which is of average risk, has an initial cost of $10 million, and
its operating cost will be $1 million per year for its 10-year life. Plan B, which is a high-risk project, has an initial
cost of $5 million, and its annual operating cost over Years 1 to 10 will be $2 million. What is the approximate PV
of costs for the better project? (VD)

A. -$5.9 million. C. -$16.8 million.

B. -$15.9 million. D. -$17.8 million. Gleim

liv
. A company's marginal cost of new capital (MCC) is 10% up to $600,000. MCC increases .5% for the next
$400,000 and another .5% thereafter. Several proposed capital projects are under consideration, with projected
cost and internal rates of return (IRR) as follows:

Project Cost IRR

A $100,000 10.5%

B $300,000 14.0%
C $450,000 10.8%

D $350,000 13.5%

E $400,000 12.0%

What should the company's capital budget be?

A. $0 C. $1,500,000

B. $1,050,000 D. $1,600,000 CIA 0589 IV-55

lv
. Five mutually exclusive projects had the following information:
A B C D E
NPV $500 $(200) $100 $200 $1,000
IRR 12% 8% 11% 13% 10%
Which project is preferred? (M)
a. A d. D
b. B e. E
c. C H&M
lvi
. As the director of capital budgeting for Denver Corporation, you are evaluating two mutually exclusive projects
with the following net cash flows:

Year Project X Cash Flow Project Z Cash Flow

0 -$100,000 -$100,000

1 50,000 10,000

2 40,000 30,000

3 30,000 40,000

4 10,000 60,000

If Denver’s cost of capital is 15 percent, which project would you choose? (E)
a. Neither project. d. Project X, since it has the higher NPV.

b. Project X, since it has the higher IRR. e. Project Z, since it has the higher IRR.

c. Project Z, since it has the higher NPV. Brigham

lvii
. Two projects being considered by a firm are mutually exclusive and have the following projected cash flows:

Year Project A Cash Flow Project B Cash Flow

0 ($100,000) ($100,000)

1 39,500 0

2 39,500 0

3 39,500 133,000
Based only on the information given, which of the two projects would be preferred, and why? (M)

a. Project A, because it has a shorter payback period.

b. Project B, because it has a higher IRR.

c. Indifferent, because the projects have equal IRRs.

d. Include both in the capital budget, since the sum of the cash inflows exceeds the initial investment in both
cases.

e. Choose neither, since their NPVs are negative. Brigham

lviii
. What is the expected value of NPV (to the nearest dollar) for the following situation? The firm expects an NPV of
$10,000 if the economy is exceptionally strong (40% probability), an NPV of $4,000 if the economy is normal
(40% probability), and an NPV of -$2,000 if the economy is exceptionally weak (20% probability). (M)

A. $5,600 C. $6,000

B. $5,200 D. None of the answers are correct. Gleim

lix
. Jackson Corporation is evaluating the following four independent, investment opportunities:

Project Cost Rate of Return

A $300,000 14%

B 150,000 10

C 200,000 13

D 400,000 11

Jackson’s target capital structure is 60 percent debt and 40 percent equity. The yield to maturity on the
company’s debt is 10 percent. Jackson will incur flotation costs for a new equity issuance of 12 percent. The
growth rate is a constant 6 percent. The stock price is currently $35 per share for each of the 10,000 shares
outstanding. Jackson expects to earn net income of $100,000 this coming year and the dividend payout ratio will
be 50 percent. If the company’s tax rate is 30 percent, which of the projects will be accepted? (M)

a. Project A

b. Projects A and C

c. Projects A, C, and D

d. All of the investment projects will be taken.

e. None of the investment projects will be taken. Brigham

lx
. Photon Corporation has a target capital structure that consists of 60 percent equity and 40 percent debt. The firm
can raise an unlimited amount of debt at a before-tax cost of 9 percent. The company expects to retain earnings
of $300,000 in the coming year and to face a tax rate of 35 percent. The last dividend (D 0) was $2 per share and
the growth rate of the company is constant at 6 percent. If the company needs to issue new equity, then the
flotation cost will be $5 per share. The current stock price (P0) is $30. Photon has the following investment
opportunities:

Project Cost IRR

1 $100,000 10.5%

2 200,000 13.0

3 100,000 12.0

4 150,000 14.0

5 75,000 9.0

What is the company’s optimal capital budget? (D)

a. $625,000 d. $550,000

b. $450,000 e. $150,000

c. $350,000 Brigham
lxi
. The investment opportunity schedule (IOS) shows, in rank order, how much money the company
would invest at different rates of return. Such schedules can be drawn only for a set of projects that
a. Have the same investment cost. c. Have the same net present value.

b. Are mutually exclusive. d. Are independent.

i
.Taxes = ($12,000 - $4,000) x 0.40 = $3,200
Cash flow = $12,000 - $3,200 = $8,800

Time line (in thousands):

0 1 2 3 4 5 6 10 Years
  
$32,448 CF -100 -500 100 110 121 133.1 146.41
Cumulative
$60,000 NCF -100 -600 -500 -390 -269 -135.9 10.51
$135.9 $63,636 . 36 $2,000 $3,000 $3,000 $1,500
$146.41 $74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

Time line:
0 k = 12% 1 2 3 8 Years
  
-275,000 73,306 73,306 73,306 73,306
NPV = ?
1
NPVA = $60,000 x - $30,000
(1 + 0.08) 4
= ($60,000 x 0.73503) - $30,000
$901,663.80 1 = $44,102 - $30,000
8
(1 + MIRR ) (1 + MIRR) 8
= $14,102
1 - (1  (1 + 0.08) 4
NPVB = $13,000 x - $30,000
0.08
1 - 0.73503
= $13,000 x  $30,000
0.08
= $13,000 x 3.31213 - $30,000
= $43,058 - $30,000
= $13,058
Time line:
Project X (in thousands):
0 k = 15% 1 2 3 4 Years

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833
Project Z (in thousands):
0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
ii

Cost of new machine $75,000

Less: After-tax inflow from old machine ($10,000 x .60) 6,000

$69,000

Time line (in thousands):

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

Time line:
0 k = 12% 1 2 3 8 Years
  
-275,000 73,306 73,306 73,306 73,306
NPV = ?
1
NPVA = $60,000 x - $30,000
(1 + 0.08) 4
= ($60,000 x 0.73503) - $30,000
$901,663.80 1 = $44,102 - $30,000
(1 + MIRR )8 (1 + MIRR)8 = $14,102
1 - (1  (1 + 0.08) 4
NPVB = $13,000 x - $30,000
0.08
1 - 0.73503
= $13,000 x  $30,000
0.08
= $13,000 x 3.31213 - $30,000
= $43,058 - $30,000
= $13,058
Time line:
Project X (in thousands):
0 k = 15% 1 2 3 4 Years

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
iii

Cost of new machine $75,000

Less: Trade-in allowance 10,000

$65,000

Time line (in thousands):

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
iv
.Answer (C) is correct. For capital budgeting purposes, the net investment is the net outlay or cash requirement. This
amount includes the cost of the new equipment, minus any cash recovered from the trade or sale of existing assets. The
investment required also includes funds to provide for increases in working capital, for example, the additional
receivables and inventories resulting from the acquisition of a new manufacturing plant. The investment in working
capital is treated as an initial cost of the investment, although it will be recovered at the end of the project (its salvage
value equals its initial cost). For Kline, the additional current assets will be 30% of sales, but current liabilities can be
used to fund assets to the extent of 10% of sales. Thus, the initial investment in working capital will equal 20% of the $6
million in sales, or $1,200,000. The total initial cash outlay will consist of the $8 million in new equipment plus
$1,200,000 in working capital, a total of $9.2 million.

Answer (A) is incorrect because $6.8 million subtracted the net investment in working capital from the cost of the
equipment. Answer (B) is incorrect because $8.6 million assumes current assets will increase by 10% of new sales but
that current liabilities will not change. Answer (D) is incorrect because $9.8 million ignores the financing of incremental
current assets with accounts payable.

Time line (in thousands):

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
xii
.Net Income After Tax (P280,000 x 20%) P 56,000

Divide by (1 – 0.30) 0.70

Net Income before Tax P 80,000

Add Depreciation 35,000

Cash Flow before Tax P115,000

Time line (in thousands):

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
xiii
.Answer (B) is correct. Payback is the number of years required to complete the return of the original investment. Given
a periodic constant cash flow, the payback period equals net investment divided by the constant expected periodic after-
tax cash flow. The desired payback period is 4 years, so the constant after-tax annual cash flow must be $90,000
($360,000 ÷ 4). Assuming that the company has sufficient other income to permit realization of the full tax savings,
depreciation of the machine will shield $60,000 ($360,000 ÷ 6) of income from taxation each year, an after-tax cash
savings of $24,000 (40% x $60,000). Thus, the machine must generate an additional $66,000 ($90,000 - $24,000) of
after-tax cash savings from operations. This amount is equivalent to $110,000 [$66,000 ÷ (1.0 - .4)] of before-tax
operating cash savings.

Answer (A) is incorrect because $90,000 is the total desired annual after-tax cash savings. Answer (C) is incorrect
because $114,000 results from adding, not subtracting, the $24,000 of tax depreciation savings to determine the
minimum annual after-tax operating savings. Answer (D) is incorrect because $150,000 assumes that depreciation is not
tax deductible.

Time line (in thousands):

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
xiv
.$1,000,000/$200,000 = 5.0 years

Time line (in thousands):

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
xv
.Step 1: Calculate the PV of the cash flows:
PVA5 = $60,000(PVIFA10%,5)
= $60,000(3.7908)
= $227,448.

Step 2: Calculate the Year 0 outflow:

The outflow at t = 0 is X where $227,448 - X = $75,000. X or CF0 = -$152,448.

Step 3: Calculate the regular payback:

Year CF Cumulative CF
0 -$152,448 -$152,448
1 60,000 -92,448
2 60,000 -32,448
$32,448
So the payback is 2 + $60,000 = 2.54 years.

Time line (in thousands):

0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833
Project Z (in thousands):
0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
xvi $60,000 .$15,000 + $20,000 + $25,000 = $60,000 or 3 years

Time line (in thousands):

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

Time line:
0 k = 12% 1 2 3 8 Years
  
-275,000 73,306 73,306 73,306 73,306
NPV = ?
1
NPVA = $60,000 x - $30,000
(1 + 0.08) 4
= ($60,000 x 0.73503) - $30,000
$901,663.80 1 = $44,102 - $30,000
(1 + MIRR ) (1 + MIRR)8
8
= $14,102
1 - (1  (1 + 0.08) 4
NPVB = $13,000 x - $30,000
0.08
1 - 0.73503
= $13,000 x  $30,000
0.08
= $13,000 x 3.31213 - $30,000
= $43,058 - $30,000
= $13,058
Time line:
Project X (in thousands):
0 k = 15% 1 2 3 4 Years

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
$32,448 CF -100 -500 100 110 121 133.1 146.41
Cumulative
xxii $60,000 NCF -100 -600 -500 -390 -269 -135.9 10.51

$135.9
$146.41 .

Discounted

Year Cash Flow Cash Flow Cumulative PV

0 -$3,000 -3,000.00 -3,000.00

1 1,000 909.09 -2,090.91

2 1,000 826.45 -1,264.46

3 1,000 751.31 -513.15

4 1,000 683.01 169.86

After Year 3, you can see that you won’t need all of Year 4 cash flows to break even. To find the portion that you need,
calculate $513.15/ $683.01 = 0.75. Therefore, the discounted payback is 3.75 years.

$63,636 . 36 $2,000 $3,000 $3,000 $1,500

$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
xxiii $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41

.
Year Cash Flow Discounted Cash Flow Cumulative Cash Flow
0 -$100,000 -$100,000.00 -$100,000.00
1 40,000 36,363.64 -63,636.36
2 90,000 74,380.17 10,743.81
3 30,000 22,539.44 33,283.25
4 60,000 40,980.81 74,264.06
$63,636 . 36
Discounted Payback = 1 + $74,380 . 17 = 1.86 years.
$2,000 $3,000 $3,000 $1,500
1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833
Project Z (in thousands):
0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
xxiv $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36
$74,380 . 17 .X = $300,000 x PV Ann 4 (12%) = $300,000 x 3.037
X= $911,100

$2,000 $3,000 $3,000 $1,500

1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

Time line:
0 k = 12% 1 2 3 8 Years
  
-275,000 73,306 73,306 73,306 73,306
NPV = ?
1
NPVA = $60,000 x - $30,000
(1 + 0.08) 4
= ($60,000 x 0.73503) - $30,000
$901,663.80 1 = $44,102 - $30,000
(1 + MIRR ) (1 + MIRR)8
8
= $14,102
1 - (1  (1 + 0.08) 4
NPVB = $13,000 x - $30,000
0.08
1 - 0.73503
= $13,000 x  $30,000
0.08
= $13,000 x 3.31213 - $30,000
= $43,058 - $30,000
= $13,058
Time line:
Project X (in thousands):
0 k = 15% 1 2 3 4 Years

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
xxv $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36
$74,380 . 17 .REUIRED: To determine the present value of the future cash savings resulting from purchase of the
new machine.
Answer (C) is correct. The present value of the $30,000 savings per year for the first 2 years is calculated using the
present value of an annuity for 2 periods. Since the amount of the cash savings drops to $20,000 in year 3, this amount
must be calculated separately. The PV of an annuity for 2 periods, equals the PV of an amount to be received 3 years
in the future. The total present value of the cash savings is calculated as follows:
PV of $30,000 for 2 periods = $30,000 x 1.65 = $49,500
PV of $20,000 in period 3 = $20,000 x (2.32 – 1.65) = 13,400
Total pesent value of cash savings $62,900
Alternatively, $20,000 could have been treated as an annuity for 3 years and an additional $10,000 for 2 years.
$2,000 $3,000 $3,000 $1,500
1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833
Project Z (in thousands):
0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
xxvi $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36
$74,380 . 17

. NPV, payback, and missing cash flow Answer: b Diff: M

First, find the missing t = 0 cash flow. If payback = 2.5 years, this implies t = 0 cash flow must be -$2,000 - $3,000 +
(0.5)$3,000 = -$6,500.

$2,000 $3,000 $3,000 $1,500

2 3 4
NPV = -$6,500 + 1. 12 + (1. 12) + (1. 12) + ( 1. 12)
= $765.91.

Time line (in thousands):

0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
xxvii $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
. NPV Answer: b Diff: M
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2
Tabular solution:
PV = $5,000(PVIFA14%,5) + $3,000(PVIFA14%,3)(PVIF14%,5)
+ $2,000(PVIFA14%,2)(PVIF14%,8)
= $5,000(3.4331) + $3,000(2.3216)(0.5194) + $2,000(1.6467)(0.3506)
= $17,165.50 + $3,617.52 + $1,154.67 = $21,937.69.

Financial calculator solution (in thousands):

Inputs: CF0 = 0; CF1 = 5; Nj = 5; CF2 = 3; Nj = 3; CF3 = 2; Nj = 2; I = 14.
Output: NPV = 21.93726 = $21,937.26.

Note: Tabular solution differs from calculator solution due to interest factor rounding.
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

  -200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFB -100,000 0 0 133,000
$32,448
xxxii $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 .Answe
r (B) is correct. The following table derives the cash flows and NPV.

Item Year 0 Years 1 to 5

Investment -80,000,000

Revenue 144,000,000

Variable cost 84,000,000

Fixed cost 25,000,000

Depreciation 16,000,000

Pre-tax profit 19,000,000

Answer (A) is incorrect because $17,225,000 results from failing to deduct depreciation in calculating taxes. Answer (C)
is incorrect because $26,780,000 results from failing to consider that depreciation is a noncash expense. Answer (D) is
incorrect because $56,117,000 is based on annual sales of 15,000 units, rather than 12,000 units.

Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

  -200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833
Project Z (in thousands):
0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
xxxiii $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 .Answe
2 2

r (B) is correct. The first step is to calculate the annual cash flows from the project for the base case (the expected
values). These may be calculated as shown:

DESCRIPTION HOW CALCULATED VALUE ($ in millions)

1. Revenues 90,000 x 0.30 x $800 21.600

2. Variable cost 90,000 x 0.30 x $400 10.800

3. Fixed cost $4,000,000 4.000

4. Depreciation $20,000,000 ÷ 8 2.500

5. Pretax profit Item 1 - (Items 2 + 3 + 4) 4.300

6. Tax Item 5 x 0.35 1.505

7. Net profit Item 5 - Item 6 2.795

8. Net cash flow Item 7 + Item 4 5.295

This level of cash flow occurs for each of the 8 years of the project. The present value of an 8-year, $1 annuity is 4.639
at 14%. The NPV of the project is therefore given by:

NPV = $5,295,000 x 4.639 - $20,000,000 = $4,563,505

Answer (A) is incorrect because $2,626,415 used the wrong discount factor. Answer (C) is incorrect because it failed to
consider depreciation. Answer (D) is incorrect because it failed to consider depreciation and other fixed costs.

Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

  -200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
xxxiv $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 .DISCU
2 2
SSION: The net present value of a project equals:
NPV = (PV of future cash flows) – (Investments)
Since this problem involves a lease requiring only annual payments there is no initial investment in this case: Lease
amortization must be subtracted from cash inflows to determine income tax expense.
$7,,500 Annual cash inflow
– 5,000 Tax basis lease amortization
$2,500 Taxable lease income
x 40%
$1,000 Tax expense per year
However, lease amortization is not a cash outflow and it thus excluded from the calculation of NPV. The after-tax
present value of the lease equals:
$7,,500 Annual cash inflow
– 1,000 Cash outflow for taxes
$6,500
x 1.74 PV factor for 2 years at 10%
$11,310

Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

  -200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
xxxv $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 .Answe
r (B) is correct. At a 10% hurdle rate, the present value of the future inflows is: 20,000 x 2.48685 = $49,737

Thus, the net present value is $4,737 (49,737 - 45,000). The profitability index calculation is:

49,737

45,000 = 1.1053

Answer (A) is incorrect because it uses the wrong present value factors. Answer (C) is incorrect because it uses the
wrong present value factors. Answer (D) is incorrect because it uses the wrong present value factors.

Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

  -200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
xxxvi $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 .
$40,000 x 6.710 (PVAF, n = 10, 8%) = $268,400

Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

  -200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
xxxvii $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 .4.355 x
$2,000 = $8,710

Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

  -200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833
Project Z (in thousands):
0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
xxxviii $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 .(b) 2 2
The maximum amount that Kern Co. should invest now to obtain a 15% internal rate of return is the present value of the
project’s total net cash flows as computer below.
Year Net cash flows x PV of an ordinary annuity = PV of net cash flows
1 $50,000 x 0.870 = $ 43,500
2 $80,000 x 0.756 = $ 60,480
Total present value $103,980

Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

  -200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
xxxix $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 .
Cash Flow Before Tax P17,863
Depreciation (P43,825  4) 10,706
Net Income Before Tax 7,157
Income Tax (40%) 2,863
Net Income 4,294
Depreciation 10,706
Cash Flow After Tax (P42,825  2.85498 P15,000

Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833
Project Z (in thousands):
0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
xl $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
.REQUIRED: To determine the annual savings needed for an investment to realize a 12% yield.
DISCUSSION: Answer (C) is correct. The internal rate of return method of capital budgeting determines the rate of
return at which the present value of the cash flows will exactly equal the investment outlay. In this problem, the desired
IRR is given and the cash flows must be determined. The necessary annual savings can be computed as follows:
TVMF x Cash flows = PV (Investment today)
3.60x = $50,000 = (.57 x $10,000)
3.60x = $44,300
x = $12,306
If the annual savings equals $12,306, the present value of the cash inflows will exactly equal the cash outflows.

Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
xli $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
.Answer (A) is correct. The factor to use is 2.5, which is found at a little under 10% on the 3-year line of an annuity table.

Answer (B) is incorrect because the factor of 2.5 is found at around 10%. Answer (C) is incorrect because the factor of
2.5 is found at around 10%. Answer (D) is incorrect because the factor of 2.5 is found at around 10%.

Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833
Project Z (in thousands):
0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
xlii $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
.Answer (D) is correct. The total cash flows are only $70,000 (5 x $14,000). Thus, whatever the discount rate, the NPV
will be less than $20,000 ($70,000 - $50,000). The return in the first year is $14,000, or 28% of the initial investment.
Since the same $14,000 flows in each year, the IRR is going to be greater than 10% (actually, it is almost 14%).

Answer (A) is incorrect because it is impossible for the NPV to be greater than $20,000, regardless of the discount rate
used. Answer (B) is incorrect because it is impossible for the NPV to be greater than $20,000, regardless of the discount
rate used. Answer (C) is incorrect because the IRR is greater; almost 14%.

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
xlv $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2  .
$52,650 = $25,000F
F = 2.106
Chart criteria for 3 years is 2.106 = 20%
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
$32,448 CF -100 -500 100 110 121 133.1 146.41
Cumulative
xlvi $60,000 NCF -100 -600 -500 -390 -269 -135.9 10.51

$135.9 $63,636 . 36 $2,000 $3,000 $3,000 $1,500

$146.41 $74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 

. IRR Answer: c Diff: M

Tabular solution:
Project A: Calculate PVIF and look in table matching period = 1 with the calculated factor value
$10,000 = $11,800(PVIFIRR,1)
0.8475 = (PVIFIRR,1)
IRRA = 18%.

Project C: Calculate the PVIFA and look in table matching period = 3 with the calculated factor value
$12,000 = $5,696(PVIFAIRR,3)
2.10674 = (PVIFAIRR,3)
IRRC  20%.

Financial calculator solution:

Project A: Inputs: N = 1; PV = -10,000; FV = 11,800.
Output: I = 18% = IRRA.

Project C: Inputs: N = 3; PV = -12,000; PMT = 5,696.

Output: I = 19.99%  20% = IRRC.
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

Time line:
0 k = 12% 1 2 3 8 Years
  
-275,000 73,306 73,306 73,306 73,306
NPV = ?
1
NPVA = $60,000 x - $30,000
(1 + 0.08) 4
= ($60,000 x 0.73503) - $30,000
$901,663.80 1 = $44,102 - $30,000
(1 + MIRR ) (1 + MIRR)8
8
= $14,102
1 - (1  (1 + 0.08) 4
NPVB = $13,000 x - $30,000
0.08
1 - 0.73503
= $13,000 x  $30,000
0.08
= $13,000 x 3.31213 - $30,000
= $43,058 - $30,000
= $13,058
Time line:
Project X (in thousands):
0 k = 15% 1 2 3 4 Years

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
xlvii $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 

. IRR Answer: c Diff: E

Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Tabular solution:
$200,000 = $44,503(PVIFAIRR,10)
PVIFAIRR,10 = 4.49408
IRR  18%.

Financial calculator solution:

Inputs: CF0 = -200,000; CF1 = 44,503; Nj = 10. Output: IRR = 18%.
Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833
Project Z (in thousands):
0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
xlviii $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503 .

Multiple IRRs Answer: c Diff: T
Time line:
0 1 2

-10,000 100,000 -100,000

Numerical solution:
This problem can be solved numerically but requires an iterative process of trial and error using the possible
solutions provided in the problem.

Investigate first claim: Try k = IRR = 13% and k = 12.5%

NPVk = 13% = -10,000 + 100,000/1.13 - 100,000/(1.13)2 = 180.91.
NPVk = 12.5% = -10,000 + 100,000/1.125 - 100,000/(1.125)2 = -123.46.
The first claim appears to be correct. The IRR of the project appears to be between 12.5% and 13.0%.

Investigate second claim: Try k = 800% and k = 780%

NPVk = 800% = -10,000 + 100,000/9 - 100,000/(1 + 8)2
= -10,000 + 11,111.11 - 1,234.57 = -123.46.

NPVk = 780% = -10,000 + 100,000/8.8 - 100,000/(1 + 7.8)2

= -10,000 + 11,363.64 - 1,291.32 = 72.32.
The second claim also appears to be correct. The IRR of the project flows also appears to be above 780% but
below 800%.

Below is a table of various discount rates and the corresponding NPVs.

Discount rate (%) NPV

12.0 ($ 433.67)
12.5 (123.46)
12.7 (1.02) IRR1  12.7%
13.0 180.91
25.0 6,000.00
400.0 6,000.00
800.0 (123.46)
787.0 2.94 IRR2  787%
780.0 72.32

By randomly selecting various costs of capital and calculating the project’s NPV at these rates, we find that there
are two IRRs, one at about 787 percent and the other at about 12.7 percent, since the NPVs are approximately
equal to zero at these values of k. Thus, there are multiple IRRs.
Time line:
0 k = 12% 1 2 3 8 Years
  
-275,000 73,306 73,306 73,306 73,306
NPV = ?
1
NPVA = $60,000 x - $30,000
(1 + 0.08) 4
= ($60,000 x 0.73503) - $30,000
$901,663.80 1 = $44,102 - $30,000
(1 + MIRR )8 (1 + MIRR)8 = $14,102
1 - (1  (1 + 0.08) 4
NPVB = $13,000 x - $30,000
0.08
1 - 0.73503
= $13,000 x  $30,000
0.08
= $13,000 x 3.31213 - $30,000
= $43,058 - $30,000
= $13,058
Time line:
Project X (in thousands):
0 k = 15% 1 2 3 4 Years

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833
Project Z (in thousands):
0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
$32,448 CF -100 -500 100 110 121 133.1 146.41
Cumulative
xlix $60,000 NCF -100 -600 -500 -390 -269 -135.9 10.51

$135.9 $63,636 . 36 $2,000 $3,000 $3,000 $1,500

$146.41 $74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

. Modified IRR Answer: d Diff: M

Time line:
0 k = 12% 1 2 3 8 Years
  
-275,000 73,306 73,306 73,306 73,306
NPV = ?
Tabular solution:
TV = $73,306(FVIFA12%,8) = $73,306(12.300) = $901,663.80.
$901,663.80
8
$275,000 = (1 + MIRR )
1
8
0.30499 = (1 + MIRR)
(1 + MIRR)8 = (FVIFIRR,8) = 3.27869.

Look in table: Periods = 8, I = 16%. MIRR = 16%.

Alternate method
3.278691/8 = 1 + MIRR
MIRR = 16%.

Financial calculator solution:

TV Inputs: N = 8; I = 12; PMT = 73,306. Output: FV = -$901,641.31.
MIRR Inputs: N = 8; PV = -275,000; FV = 901,641.31. Output: I = 16.0%.

Alternate method
Inputs: CF0 = 0; CF1 = 73,306; Nj = 8; I = 12. Output: NFV = $901,641.31.
Inputs: CF0 = -275,000; CF1 = 0; Nj = 7; CF2 = 901,641.31.
Output: IRR = 16.0% = MIRR.
1 - (1  (1 + 0.08) 4
NPVB = $13,000 x - $30,000
0.08
1 1 - 0.73503
NPVA = $60,000 x - $30,000 = $13,000 x  $30,000
(1 + 0.08) 4 0.08
= ($60,000 x 0.73503) - $30,000 = $13,000 x 3.31213 - $30,000
= $44,102 - $30,000 = $43,058 - $30,000
= $14,102 = $13,058
Time line:
Project X (in thousands):
0 k = 15% 1 2 3 4 Years

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
l $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

Time line:
0 k = 12% 1 2 3 8 Years
  
-275,000 73,306 73,306 73,306 73,306
NPV = ?
$901,663.80 1
(1 + MIRR )8 (1 + MIRR)8 ROR = [(1 x 1.09)5 x 93%]/9%
= 1.54 x 93% / 9%
= 15.91% = 16%

1 - (1  (1 + 0.08) 4
NPVB = $13,000 x - $30,000
0.08
1 1 - 0.73503
NPVA = $60,000 x 4
- $30,000 = $13,000 x  $30,000
(1 + 0.08) 0.08
= ($60,000 x 0.73503) - $30,000 = $13,000 x 3.31213 - $30,000
= $44,102 - $30,000 = $43,058 - $30,000
= $14,102 = $13,058
Time line:
Project X (in thousands):
0 k = 15% 1 2 3 4 Years

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833
Project Z (in thousands):
0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
li $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

Time line:
0 k = 12% 1 2 3 8 Years
  
-275,000 73,306 73,306 73,306 73,306
NPV = ?
$901,663.80 1
(1 + MIRR ) (1 + MIRR)8 .Answer (C) is correct. The cost of capital at which the two projects will produce the
8

same NPV can be found by calculating the IRR of the difference in cash flows between the two projects. Proposal A
requires an additional investment of $53,000 and generates extra cash flows of $15,000 for 6 years. The IRR for this set
of cash flows exceeds 16% but is less than 18%. This further means that, for any cost of capital below this range,
Proposal A will have a higher NPV, and, for any cost of capital above this range, Proposal B will have a higher NPV.
Answer (A) is incorrect because Proposal A would be superior. Answer (B) is incorrect because Proposal A would be
superior. Answer (D) is incorrect because Proposal B would be superior. Proposal A would have a negative NPV with
regard to the incremental cash flows.

1 - (1  (1 + 0.08) 4
NPVB = $13,000 x - $30,000
0.08
1 1 - 0.73503
NPVA = $60,000 x - $30,000 = $13,000 x  $30,000
(1 + 0.08) 4 0.08
= ($60,000 x 0.73503) - $30,000 = $13,000 x 3.31213 - $30,000
= $44,102 - $30,000 = $43,058 - $30,000
= $14,102 = $13,058
Time line:
Project X (in thousands):
0 k = 15% 1 2 3 4 Years

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
lii $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

Time line:
0 k = 12% 1 2 3 8 Years
  
-275,000 73,306 73,306 73,306 73,306
NPV = ?
$901,663.80 1
(1 + MIRR ) (1 + MIRR)8 .Answer (A) is correct. The NPV of both machines must be calculated and compared to
8

determine which will yield a better return of cash flows. Machine A is calculated as one lump sum payable in 4 years
minus the initial investment cost.

1
NPVA = $60,000 x - $30,000
(1 + 0.08) 4
= ($60,000 x 0.73503) - $30,000
= $44,102 - $30,000
= $14,102

The NPV of Machine B is calculated as the present value of an ordinary annuity of $13,000 for 4 years, minus the initial
investment cost.

1 - (1  (1 + 0.08) 4
NPVB = $13,000 x - $30,000
0.08
1 - 0.73503
= $13,000 x  $30,000
0.08
= $13,000 x 3.31213 - $30,000
= $43,058 - $30,000
= $13,058

By comparing the NPV of both machines, Cliff would choose Machine A because NPVA > NPVB by $1,044.

Answer (B) is incorrect because Machine A is a better choice. Answer (C) is incorrect because the difference is $1,044.
Answer (D) is incorrect because Machine A has the higher NPV.
Time line:
Project X (in thousands):
0 k = 15% 1 2 3 4 Years

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
liii $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

Time line:
0 k = 12% 1 2 3 8 Years
  
-275,000 73,306 73,306 73,306 73,306
NPV = ?

1
NPVA = $60,000 x - $30,000
(1 + 0.08) 4
= ($60,000 x 0.73503) - $30,000
$901,663.80 1 = $44,102 - $30,000
(1 + MIRR ) (1 + MIRR)8
8
= $14,102

1 - (1  (1 + 0.08) 4
NPVB = $13,000 x - $30,000
0.08
1 - 0.73503
= $13,000 x  $30,000
0.08
= $13,000 x 3.31213 - $30,000
= $43,058 - $30,000
= $13,058 .Answer (B) is correct. The first thing to note is that risky
cash outflows are discounted at a lower discount rate, so in this case we discount the riskier Project B's cash flows at
11% - 2% = 9%. Project A's cash flows are discounted at 11%. We would find the PV of the costs as follows:

Project A Project B

CF0 = -10,000,000 CF0 = -5,000,000

CF1-10 = -1,000,000 CF1-10 = -2,000,000

I = 11.0% I = 9.0%

Solve for NPV = -$15,889,232 Solve for NPV = -$17,835,315Project A has the lower PV of costs. Project B is evaluated
with a lower cost of capital, 9%, reflecting greater risk of the cash outflow only project. This is somewhat tricky, because
CMA candidates typically think about raising the discount rate because of risk, but that is when revenues or net cash
inflows are subject to risk. The discount rate is lowered to reflect risk when only costs are subject to risk.

Answer (A) is incorrect because -$5.9 million results from failing to consider the initial $10 million outlay. Answer (C) is
incorrect because -$16.8 million is based on the wrong discount. Answer (D) is incorrect because -$17.8 million is the
NPV for Project B, which is not as good as Project A.
Time line:
Project X (in thousands):
0 k = 15% 1 2 3 4 Years

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
liv $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

Time line:
0 k = 12% 1 2 3 8 Years
  
-275,000 73,306 73,306 73,306 73,306
NPV = ?

1
NPVA = $60,000 x - $30,000
(1 + 0.08) 4
= ($60,000 x 0.73503) - $30,000
$901,663.80 1 = $44,102 - $30,000
(1 + MIRR ) (1 + MIRR)8
8
= $14,102

1 - (1  (1 + 0.08) 4
NPVB = $13,000 x - $30,000
0.08
1 - 0.73503
= $13,000 x  $30,000
0.08
= $13,000 x 3.31213 - $30,000
= $43,058 - $30,000
= $13,058 .Answer (B) is correct. The IRR is the discount rate at
which the net present value (discounted net cash inflows - investment) of a project is zero. Hence, an investment should
be profitable if the IRR exceeds the company's cost of capital. Projects B, D, and E, with a combined cost of $1,050,000,
have the highest IRRs. Each is in excess of the company's maximum 11% cost of capital (10% + .5% + .5%). Because
their combined cost exceeds the level ($1,000,000) at which the cost of capital rises to 11%, Projects A (10.5%) and C
(10.8%) must be rejected using the IRR criterion.

Answer (A) is incorrect because the IRRs for B, D, and E exceed the cost of capital. Answer (C) is incorrect because
project C should be rejected. Answer (D) is incorrect because projects A and C should be rejected.
Time line:
Project X (in thousands):
0 k = 15% 1 2 3 4 Years

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
lv $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

Time line:
Project X (in thousands):
0 k = 15% 1 2 3 4 Years

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
$32,448
lvi $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

Time line:
0 k = 12% 1 2 3 8 Years
  
-275,000 73,306 73,306 73,306 73,306
NPV = ?
1
NPVA = $60,000 x - $30,000
(1 + 0.08) 4
= ($60,000 x 0.73503) - $30,000
$901,663.80 1 = $44,102 - $30,000
8
(1 + MIRR ) (1 + MIRR) 8
= $14,102
1 - (1  (1 + 0.08) 4
NPVB = $13,000 x - $30,000
0.08
1 - 0.73503
= $13,000 x  $30,000
0.08
= $13,000 x 3.31213 - $30,000
= $43,058 - $30,000
= $13,058 .
Time line:
Project X (in thousands):
0 k = 15% 1 2 3 4 Years

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
At a cost of capital of 15%, both projects have negative NPVs and, thus, both would be rejected.
Tabular solution (in thousands):

NPVX = -100 + 50(PVIF15%,1) + 40(PVIF15%,2) + 30(PVIF15%,3) + 10(PVIF15%,4)

= -100 + 50(0.8696) + 40(0.7561) + 30(0.6575) + 10(0.5718)

= -0.833 = -$833.

NPVZ = -100 + 10(PVIF15%,1) + 30(PVIF15%,2) + 40(PVIF15%,3) + 60(PVIF15%,4)

= -100 + 10(0.8696) + 30(0.7561) + 40(0.6575) + 60(0.5718)

= -8.013 = -$8,013.

Financial calculator solution (in thousands):

Project X: Inputs: CF0 = -100; CF1 = 50; CF2 = 40; CF3 = 30;

CF4 = 10; I = 15.

Output: NPVX = -0.833 = -$833.

Project Z: Inputs: CF0 = -100; CF1 = 10; CF2 = 30; CF3 = 40;

CF4 = 60; I = 15.

Output: NPVZ = -8.014 = -$8,014.

Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
$32,448 CF -100 -500 100 110 121 133.1 146.41
Cumulative
lvii $60,000 NCF -100 -600 -500 -390 -269 -135.9 10.51

$135.9 $63,636 . 36 $2,000 $3,000 $3,000 $1,500

$146.41 $74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

Time line:
0 k = 12% 1 2 3 8 Years
  
-275,000 73,306 73,306 73,306 73,306
NPV = ?

1
NPVA = $60,000 x - $30,000
(1 + 0.08) 4
= ($60,000 x 0.73503) - $30,000
$901,663.80 1 = $44,102 - $30,000
(1 + MIRR )8 (1 + MIRR)8 = $14,102

1 - (1  (1 + 0.08) 4
NPVB = $13,000 x - $30,000
0.08
1 - 0.73503
= $13,000 x  $30,000
0.08
= $13,000 x 3.31213 - $30,000
= $43,058 - $30,000
= $13,058

Time line:
Project X (in thousands):
0 k = 15% 1 2 3 4 Years

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833
Project Z (in thousands):
0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.

. Mutually exclusive projectsAnswer: b Diff: M

Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000

Tabular solution:
Solve for numerical PVIFA and PVIF, then obtain corresponding interest rate from table.
Project A: $100,000 = 39,500(PVIFAIRRA,3)
2.53165 = PVIFAIRRA,3
IRRA  9%

Project B: $100,000 = 133,000(PVIFIRRB,3)

0.75188 = PVIFIRRB,3
IRRB  10%
The firm’s cost of capital is not given in the problem; use IRR decision rule. Since IRRB > IRRA; Project B is
preferred.

Financial calculator solution:

Project A: Inputs: CF0 = -100,000; CF1 = 39,500; Nj = 3.
Output: IRRA = 8.992%  9.0%.

Project B: Inputs: CF0 = -100,000; CF1 = 0; Nj = 2; CF2 = 133,000.

Output: IRRB = 9.972%  10.0%.
$32,448
lviii $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

Time line:
0 k = 12% 1 2 3 8 Years
  
-275,000 73,306 73,306 73,306 73,306
NPV = ?

1
NPVA = $60,000 x - $30,000
(1 + 0.08) 4
= ($60,000 x 0.73503) - $30,000
$901,663.80 1 = $44,102 - $30,000
(1 + MIRR )8 (1 + MIRR)8 = $14,102

1 - (1  (1 + 0.08) 4
NPVB = $13,000 x - $30,000
0.08
1 - 0.73503
= $13,000 x  $30,000
0.08
= $13,000 x 3.31213 - $30,000
= $43,058 - $30,000
= $13,058

Time line:
Project X (in thousands):
0 k = 15% 1 2 3 4 Years

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833
Project Z (in thousands):
0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.

Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000 .Answer
(B) is correct. Each of the three alternatives are weighted by their probabilities:

$10,000 x .40 = $4,000

4,000 x .40 = 1,600

-2,000 x .20 = -400

$5,200

Answer (A) is incorrect because $5,600 fails to deduct for the possibility of a negative return. Answer (C) is incorrect
because $6,000 adds, rather than deducts, the negative return. Answer (D) is incorrect because the answer is $5,200.

$32,448
lix $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000 .Calculate
the after-tax component cost of debt as 10%(1 - 0.3) = 7%. If the company has earnings of $100,000 and pays out 50%
or $50,000 in dividends, then it will retain earnings of $50,000. The retained earnings breakpoint is $50,000/0.4 =
$125,000. Since it will require financing in excess of $125,000 to undertake any of the alternatives, we can conclude the
firm must issue new equity. Therefore, the pertinent component cost of equity is the cost of new equity. Calculate the
expected dividend per share (note this is D1) as $50,000/10,000 = $5. Thus, the cost of new equity is $5/[($35(1 - 0.12)]
+ 6% = 22.23%. Jackson’s WACC is 7%(0.6) + 22.23%(0.4) = 13.09%. Only the return on Project A exceeds the WACC,
so only Project A will be undertaken.
$32,448
lx $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833
Project Z (in thousands):
0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000.Calculate
the retained earnings break point (BPRE) as $300,000/0.6 = $500,000. Calculate ks as D1/P0 + g = $2(1.06)/$30 + 6% =
13.07%. Calculate ke as D1/(P0 - F) + g = $2(1.06)/($30 - $5) + 6% = 14.48%. Find WACC below BPRE as: WACC =
0.6(13.07%)+ 0.4(9%)(1 - 0.35) = 10.18%. Thus, up to $500,000 can be financed at 10.18%. Find WACC above BPRE
as: WACC = 0.6(14.48%) + 0.4(9%)(1 - 0.35) = 11.03%. Thus, financing in excess of $500,000 costs 11.03%. Projects
2, 3, and 4 all have IRRs exceeding either WACC and should be accepted. These projects require $450,000 in
financing. Project 1 is the next most profitable project. Given its cost of $100,000, half or $50,000 can be financed at
10.18% and the other half must be financed at 11.03%. The relevant cost of capital for Project 1 is then 0.5(10.18%) +
0.5(11.03%) = 10.61%. Since Project 1’s IRR is less than the cost of capital, it should not be accepted. The firm’s
optimal capital budget is $450,000.

$32,448
lxi $60,000
Time line (in thousands):
0 1 2 3 4 5 6 10 Years
  
CF -100 -500 100 110 121 133.1 146.41 $135.9
Cumulative
NCF -100 -600 -500 -390 -269 -135.9 10.51 $146.41
$63,636 . 36 $2,000 $3,000 $3,000 $1,500
$74,380 . 17 1. 12 (1. 12)2 (1. 12)3 ( 1. 12)4
Time line (in thousands):
0 k = 14% 1 2 3 4 5 6 7 8 9 10 Yrs.

PV = ? 5 5 5 5 5 3 3 3 2 2 
Time line:
k = 14%
0 IRR = ? 1 2 10 Years
  

-200,000 44,503 44,503 44,503

Time line:
0 1 2

-10,000 100,000 -100,000

CFX -100 50 40 30 10
k = 15%
43.478
k = 15%
30.246
k = 15%
19.725
k = 15%
5.718
NPVx = -0.833 = -$833

Project Z (in thousands):

0 1 2 3 4 Years
k = 15%

CFZ -100 10 30 40 60
k = 15%
8.696 k = 15%
22.684 k = 15%
26.301 k = 15%
34.30
NPVZ = -8.014 = -$8,014.
Time line:
IRRA = ?
0 IRRB = ? 1 2 3 Years

CFA -100,000 39,500 39,500 39,500

CFB -100,000 0 0 133,000 .REQUIR
ED: The characteristics of projects on an IOS.
DISCUSSION: (D) An IOS schedule is drawn for a set of independent projects. The decision to be made is whether to
accept or reject each project without regard to other investment opportunities. Thus, the cash flows of one independent
project are not influenced by those of another. Independence should distinguished from mutual exclusivity. Projects are
mutually exclusive if acceptance of one requires rejection of the other.
Answer (A) is incorrect because IOS schedules do not require that all projects have the same investment cost. The
steps of the schedule can be of varying lengths. Answer (B) is incorrect because IOS schedules cannot be drawn for
mutually exclusive projects. Answer (C) is incorrect because IOS schedules do not require that all projects have the
same NPV. The NPV of each project depends on the investment cost and on the present value of the expected cash
flows. Both costs and cash flows can vary for projects on an IOS.

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