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Tutorial Chapter 9 (Week 4) A

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23 views

Tutorial Chapter 9 (Week 4) A

Uploaded by

winnietsj
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© © All Rights Reserved
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Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 9

Tutorial Chapter 9

Answer
To calculate the payback period, we need to find the time that the project requires to recover
its initial investment. After three years, the project has created:

$1,900 + 3,000 + 2,300 = $7,200


in cash flows. The project still needs to create another:

$7,700 – 7,200 = $500


in cash flows. During the fourth year, the cash flows from the project will be $1,700. So, the
payback period will be three years, plus what we still need to make divided by what we will
make during the fourth year. The payback period is:

Payback = 3 + ($500/$1,700)
Payback = 3.29 years
Answer
To calculate the payback period, we need to find the time that the project requires to recover
its initial investment. The cash flows in this problem are an annuity, so the calculation is
simpler. If the initial cost is $1,900, the payback period is:
Payback = 2 + ($230/$835)
Payback = 2.28 years

There is a shortcut to calculate payback period when the project cash flows are an annuity.
Just divide the initial cost by the annual cash flow. For the $3,600 cost, the payback period is:
Payback = $3,600/$835
Payback = 4.31 years

The payback period for an initial cost of $7,400 is a little trickier. Notice that the total cash
inflows after eight years will be:
Total cash inflows = 8($835)
Total cash inflows = $6,680
If the initial cost is $7,400, the project never pays back. Notice that if you use the shortcut for
annuity cash flows, you get:
Payback = $7,400/$835
Payback = 8.86 years
This answer does not make sense since the cash flows stop after eight years, so again, we
must conclude the payback period is never.
Answer
When we use discounted payback, we need to find the value of all cash flows today. The
value today of the project cash flows for the first four years is:
Value today of Year 1 cash flow = $2,800/1.09 = $2,568.81
Value today of Year 2 cash flow = $3,700/1.092 = $3,114.22
Value today of Year 3 cash flow = $5,100/1.093 = $3,938.14
Value today of Year 4 cash flow = $4,300/1.094 = $3,046.23

To find the discounted payback, we use these values to find the payback period. The
discounted first year cash flow is $2,568.81, so the discounted payback for a $5,200 initial
cost is:
Discounted payback = 1 + ($5,200 – 2,568.81)/$3,114.22
Discounted payback = 1.84 years

For an initial cost of $6,400, the discounted payback is:


Discounted payback = 2 + ($6,400 – 2,568.81 – 3,114.22)/$3,938.14
Discounted payback = 2.18 years
Notice the calculation of discounted payback. We know the payback period is between two
and three years, so we subtract the discounted values of the Year 1 and Year 2 cash flows
from the initial cost. This is the numerator, which is the discounted amount we still need to
make to recover our initial investment. We divide this amount by the discounted amount we
will earn in Year 3 to get the fractional portion of the discounted payback.
If the initial cost is $10,400, the discounted payback is:
Discounted payback = 3 + ($10,400 – 2,568.81 – 3,114.22 – 3,938.14)/$3,046.23
Discounted payback = 3.26 years
Answer
Our definition of AAR is the average net income divided by the average book value. The
average net income for this project is:
Average net income = ($1,430,000 + 1,523,460 + 1,716,300 + 1,097,400)/4
Average net income = $1,441,790

And the average book value is:


Average book value = ($12,600,000 + 0)/2
Average book value = $6,300,000

So, the AAR for this project is:


AAR = Average net income/Average book value
AAR = $1,441,790/$6,300,000
AAR = .2289, or 22.89%
Answer
The NPV of a project is the PV of the inflows minus the PV of the outflows. The equation for
the NPV of this project at an 11 percent required return is:
NPV = –$41,000 + $20,000/1.11 + $23,000/1.112 + $14,000/1.113
NPV = $5,922.01
At a required return of 11 percent, the NPV is positive, so we would accept the project.

The equation for the NPV of the project at a 24 percent required return is:
NPV = –$41,000 + $20,000/1.24 + $23,000/1.242 + $14,000/1.243
NPV = –$2,569.77
At a required return of 24 percent, the NPV is negative, so we would reject the project.
Answer
The NPV of a project is the PV of the inflows minus the PV of the outflows. At a zero
discount rate (and only at a zero discount rate), the cash flows can be added together across
time. So, the NPV of the project at a zero percent required return is:
NPV = –$18,700 + 9,400 + 10,400 + 6,500
NPV = $7,600

The NPV at a 10 percent required return is:


NPV = –$18,700 + $9,400/1.1 + $10,400/1.12 + $6,500/1.13
NPV = $3,324.04

The NPV at a 20 percent required return is:


NPV = –$18,700 + $9,400/1.2 + $10,400/1.22 + $6,500/1.23
NPV = $117.13

And the NPV at a 30 percent required return is:


NPV = –$18,700 + $9,400/1.3 + $10,400/1.32 + $6,500/1.33
NPV = –$2,356.80

Notice that as the required return increases, the NPV of the project decreases. This will
always be true for projects with conventional cash flows. Conventional cash flows are
negative at the beginning of the project and positive throughout the rest of the project.
Answer
a. The payback period for each project is:
A: 3 + ($144,000/$366,000) = 3.39 years
B: 2 + ($4,000/$17,200) = 2.23 years
The payback criterion implies accepting Project B, because it pays back sooner than
Project A.

b. The discounted payback for each project is:


A: $37,000/1.11 + $55,000/1.112 + $55,000/1.113 = $118,188.09
$366,000/1.114 = $241,095.54
Discounted payback = 3 + ($291,000 – 118,188.09)/$241,095.54
Discounted payback = 3.72 years

B: $20,000/1.11 + $17,600/1.112 = $32,302.57


$17,200/1.113 = $12,576.49
Discounted payback = 2 + ($41,600 – 32,302.57)/$12,576.49
Discounted payback = 2.74 years
The discounted payback criterion implies accepting Project B because it pays back sooner than
A.
c. The NPV for each project is:
A: NPV = –$291,000 + $37,000/1.11 + $55,000/1.112 + $55,000/1.113 +
$366,000/1.114
NPV = $68,283.63
B: NPV = –$41,600 + $20,000/1.11 + $17,600/1.112 + $17,200/1.113 +
$14,000/1.114
NPV = $12,501.30
NPV criterion implies we accept Project A because Project A has a higher NPV than Project B.

d. The IRR for each project is:


A: $291,000 = $37,000/(1+IRR) + $55,000/(1+IRR)2 + $55,000/(1+IRR)3
+ $366,000/(1+IRR)4
Using a spreadsheet, financial calculator, or trial and error to find the root of the
equation, we find that:
IRR = 18.26%

B: $41,600 = $20,000/(1+IRR) + $17,600/(1+IRR)2 + $17,200/(1+IRR)3


+ $14,000/(1+IRR)4
Using a spreadsheet, financial calculator, or trial and error to find the root of
the equation, we find that:
IRR = 25.29%
IRR decision rule implies we accept Project B because IRR for B is greater than IRR for A.

e. The profitability index for each project is:


A: PI = ($37,000/1.11 + $55,000/1.112 + $55,000/1.113 +
$366,000/1.114)/$291,000
PI = 1.235

B: PI = ($20,000/1.11 + $17,600/1.112 + $17,200/1.113 + $14,000/1.114)/$41,600


PI = 1.301
Profitability index criterion implies we accept Project B because the PI for B is greater than
the PI for A.
f. In this instance, the NPV criteria implies that you should accept Project A, while
profitability index, payback period, discounted payback, and IRR imply that you
should accept Project B. The final decision should be based on the NPV since it
does not have the ranking problem associated with the other capital budgeting
techniques. Therefore, you should accept Project A.

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