Chapter4TimeValueofMoney71

Principles of Managerial Finance

Arab World Edition
Gitman, Zutter, Elali, Al-Roubaie

Part

Long-Term Investment
Decisions
ChaptersinthisPart
Chapter8

CapitalBudgetingTechniques

Chapter9

CapitalBudgetingCashFlows

Chapter10

RiskandRefinementsinCapitalBudgeting

Chapter 8

Capital Budgeting Techniques

Instructors Resources
Overview
Thischaptercontinuesthediscussionofcapitalbudgetingbegunintheprecedingchapter(Chapter7),
whichestablishedthebasicprinciplesofdeterminingrelevantcashflows.Boththesophisticated[net
presentvalue(NPV)andtheinternalrateofreturn(IRR)]andunsophisticated(averagerateofreturnand
paybackperiod)capitalbudgetingtechniquesarepresented.Discussioncentersonthecalculationand
evaluationoftheNPVandIRRininvestmentdecisions,withandwithoutacapitalrationingconstraint.
Severalillustrationsexistexplainingwhycapitalbudgetingtechniqueswillbeusefultostudentsintheir
professionalandpersonallife.

Answers to Review Questions

81

Whatisthefinancialmanagersgoalinselectinginvestmentprojectsforthefirm?Definethe
capitalbudgetingprocessandexplainhowithelpsmanagersachievetheirgoal.
Oncetherelevantcashflowshavebeendeveloped,theymustbeanalyzedtodeterminewhetherthe
projectsareacceptableortoranktheprojectsintermsofacceptabilityinmeetingthefirmsgoal.
Managersreachtheirgoalofmaximizingshareholderwealthwhentheyundertakeallinvestments
whereinthepresentvalueofthecashinflowsexceedsthepresentvalueofcashoutflows.

82

Whatisthepaybackperiod?Howisitcalculated?
Thepaybackperiodistheexactamountoftimerequiredtorecoverthefirmsinitialinvestmentina
project.Inthecaseofamixedstream,thecashinflowsareaddeduntiltheirsumequalstheinitial
investmentintheproject.Inthecaseofanannuity,thepaybackiscalculatedbydividingtheinitial
investmentbytheannualcashinflow.

83

Whatweaknessesarecommonlyassociatedwiththeuseofthepaybackperiodtoevaluatea
proposedinvestment?

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

Theweaknessesofusingthepaybackperiodare(1)noexplicitconsiderationofshareholders
wealth;(2)failuretotakefullyintoaccountthetimevalueofmoney;and(3)failuretoconsider
returnsbeyondthepaybackperiodand,hence,overallprofitabilityofprojects.[Note:Ifyoudiscount
eachcashflowatthetimevalueofmoneyandsubtractthatfromtheoriginalexpenditure,youendup
witharevisedpaybackperiod,usuallycalledthediscountedpaybackperiod.However,thistechnique
stilldoesnotconsiderallofthecashflows.]
84

Howisthenetpresentvalue(NPV)calculatedforaprojectwithaconventionalcashflow
pattern?
NPVcomputesthepresentvalueofallrelevantcashflowsassociatedwithaproject.For
conventionalcashflow,NPVtakesthepresentvalueofallcashinflowsoveryears1throughnand
subtractsfromthatsumtheinitialinvestmentattimezero.TheformulafortheNPVofaproject
withconventionalcashflowsis:
NPVpresentvalueofcashinflowsinitialinvestment

85

WhataretheacceptancecriteriaforNPV?Howaretheyrelatedtothefirmsmarketvalue?
AcceptancecriterionfortheNPVmethodisifNPV>0,accept;ifNPV<0,reject.Ifthefirm
undertakesprojectswithapositiveNPV,themarketvalueofthefirmshouldincreasebytheamount
oftheNPV.

86

ExplainthesimilaritiesanddifferencesbetweenNPV,PI,andEVA.
NPV,PI,andEVAareallbasedonthesameunderlyingidea,thatinvestmentsshouldearnarateof
returnhighenoughtomeetinvestorsexpectations.ThePIdiffersfromNPVinthatitisexpressedas
arateofreturn.Thatis,itmeasuresthepresentvalueofaninvestmentscashinflowsrelativetothe
upfrontcashoutflow.EVAcalculatesacostofcapitalchargewhichisdeductedeachyearfroma
projectscashflows.TocalculatetheoverallprojectEVA,youtaketheannualEVAfiguresand
discountthematthecostofcapital.Ingeneral,NPV,PI,andEVAwillalwaysagreeonwhethera
projectisworthinvestinginornot.

87

Whatistheinternalrateofreturn(IRR)onaninvestment?Howisitdetermined?
TheIRRonaninvestmentisthediscountratethatwouldcausetheinvestmenttohaveaNPVof
zero.ItisfoundbysolvingtheNPVequationgivenbelowforthevalueofkthatequatesthepresent
valueofcashinflowswiththeinitialinvestment.
CFt
I0
t
t 1 (1 r )
n

NPV

Chapter8CapitalBudgetingTechniques

88

WhataretheacceptancecriteriaforIRR?Howaretheyrelatedtothefirmsmarketvalue?
IfaprojectsIRRisgreaterthanthefirmscostofcapital,theprojectshouldbeaccepted;otherwise,
theprojectshouldberejected.IftheprojecthasanacceptableIRR,thevalueofthefirmshould
increase.UnliketheNPV,theamountoftheexpectedvalueincreaseisnotknown.

89

Dothenetpresentvalue(NPV)andinternalrateofreturn(IRR)alwaysagreewithrespectto
acceptrejectdecisions?Withrespecttorankingdecisions?Explain.
TheNPVandIRRalwaysprovideconsistentaccept/rejectdecisions.Thesemeasures,however,may
notagreewithrespecttorankingtheprojects.TheNPVmayconflictwiththeIRRduetodifferent
cashflowcharacteristicsoftheprojects.Thegreaterthedifferencebetweentimingandmagnitude
ofcashinflows,themorelikelyitisthatrankingswillconflict.

810 Howisanetpresentvalueprofileusedtocompareprojects?Whatcausesconflictsinthe
rankingofprojectsvianetpresentvalueandinternalrateofreturn?
ANPVisagraphicrepresentationoftheNPVofaprojectatvariousdiscountrates.TheNPVprofile
maybeusedwhenconflictingrankingsofprojectsexistbydepictingeachprojectasalineonthe
profileanddeterminingthepointofintersection.Iftheintersectionoccursatapositivediscountrate,
anydiscountratebelowtheintersectionwillcauseconflictingrankings,whereasanydiscountrates
abovetheintersectionwillprovideconsistentrankings.ConflictsinprojectrankingsusingNPVand
IRRresultfromdifferencesinthemagnitudeandtimingofcashflows.Projectswithsimilarsized
investmentshavinglowearlyyearcashinflowstendtobepreferredatlowerdiscountrates.Athigh
discountrates,projectswiththehigherearlyyearcashinflowsarefavored,aslateryearcashinflows
tendtobeseverelypenalizedinpresentvalueterms.
811 Doestheassumptionconcerningthereinvestmentofintermediatecashinflowtendtofavor
NPVorIRR?Inpractice,whichtechniqueispreferredandwhy?
Thereinvestmentrateassumptionreferstotherateatwhichreinvestmentofintermediatecash
flowstheoreticallymaybeachievedundertheNPVortheIRRmethods.TheNPVmethodassumes
theintermediatecashflowsarereinvestedatthediscountrate,whereastheIRRmethodassumes
intermediatecashflowsarereinvestedattheIRR.Onapurelytheoreticalbasis,theNPVs
reinvestmentrateassumptionissuperiorbecauseitprovidesamorerealisticrate,thefirmscost
ofcapital,forreinvestment.Thecostofcapitalisgenerallyareasonableestimateoftherateat
whichafirmcouldreinvestthesecashinflows.TheIRR,especiallyonewellexceedingthecostof
capital,mayassumeareinvestmentratethefirmcannotachieve.Inpractice,theIRRispreferred
duetothegeneraldispositionofbusinesspeopletowardratesofreturnratherthanpuredollar
returns.

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

Suggested Answer to Focus on Practice Box:

Limits on Payback Analysis
Inyourview,ifthepaybackperiodmethodisusedinconjunctionwiththeNPVmethod,shoulditbe
usedbeforeoraftertheNPVevaluation?
Whilethepaybackmethodissimpletouseandcanbeusedtoinitiallyscreenprojects,themajor
disadvantageisthataveryrewardingprojectmaybeoverlookedifitdoesnotmeetthearbitrarypayback
period.Forexample,ifallprojectsthatdonotmakeaspecifiedpaybackperiodsay,3yearsare
rejected,thecompanymightforgoaveryrewardingprojectwhosepaybackisjustifiedat,say,3.5years.
TheprojectsmostlikelyrejectedbythepaybackanalysisthatcouldbeacceptableusingtheNPVmethod
arethosethatareslowtoprovideareturncashflowinearlyyears,butthatprovideasignificantcashflow
inoutlyingyears.However,thefartheroutthecashflowsare,themoreuncertaintheybecome.
Therefore,ifthereisanabundanceofprojectstoevaluate,itmaymakesensetouseasimplemethodsuch
asthepaybackperiodanalysistowinnowdowntheprojectsbeforeapplyingamoresophisticatedmethod,
suchastheNPVmethod,tothesurvivors.Ifthereisnotanabundanceofprojectsoriftimeallows,it
makessensetoapplymorethanonemethodofanalysistoalloftheprojectsbeforemakingafinal
decision.
Anothervariationistoextendthepaybackperiodanextrayearontheinitialscreensothatthoseprojects
justbeyondthepreferredpaybackhorizonaregivenasecondchance.

Suggested Answer to Focus on Ethics Box:

Nonfinancial Considerations in Project Selection
Whatarethepotentialriskstoacompanyofunethicalbehaviorsbyemployees?Whatarepotential
riskstothepublicandtostakeholders?
Theconsequencestothecompanymayincludeprosecution,fines,andotherpenaltiesfortheimproper
conductofitsemployees.Legalsanctionsbringunwantedpublicitythatcanresultinlossofbusinessor
damagetothecompanysgoodname,tradeandcustomerrelations,andevenfuturebusinessopportunities.
Consequencesfortheemployeecanincludeprosecution,fines,andimprisonment.Otherpenaltiesfor
improperconductcanincludelossofincentivepayandannualincreasesandotherformsofdisciplinary
actionasdeterminedbythecompany.Seriousunethicalbehaviorwillalmostcertainlyleadtotermination
ofemployment,nottomentiondamagetotheemployeespersonalreputation.
Consequencesforthepublic,dependinguponthetypesofproductsthefirmproduces,mayrangefrom
compromisedproductsafety,anincreasedenvironmentalrisk,andalossoffaithinthecompany.
Consequencesforinvestorsmaybeareducedinvestmentvalue.

Chapter8CapitalBudgetingTechniques

Answers to Warm-Up Exercises

E81.
Answer:

Paybackperiod
ThepaybackperiodforProjectHydrogenis4.29years.ThepaybackperiodforProject
Heliumis5.75years.Bothprojectsareacceptablebecausetheirpaybackperiodsarelessthan
ElyasFieldsmaximumpaybackperiodcriterionof6years.

E82.
Answer:

NPV

Year

CashInflow

1
2
3
4
5

$400,000
375,000
300,000
350,000
200,000
Total

PresentValue
$377,358.49
333,748.67
251,885.78
277,232.78
149,451.63
$1,389,677.35

NPV$1,389,677.35$1,250,000$139,677.35
NadaFoodsshouldacquirethenewwrappingmachine.
E83:
Answer:

NPVcomparisonoftwoprojects
ProjectK
Presentvalueofexpenses
Presentvalueofcashinflows
NPV

$45,000
51,542(PMT$20,000,N3,I8,PV?)
$6,542

ProjectT
Presentvalueofexpenses

$275,000

Presentvalueofcashinflows
277,373(PMT$60,000,N6,I8,PV?)
NPV
$2,373
BasedonNPVanalysis,AxisCorporationshouldchooseanoverhauloftheexistingsystem.
E84:
Answer:

IRR
YoumayuseafinancialcalculatortodeterminetheIRRofeachproject.Choosetheproject
withthehigherIRR.
ProjectTShirt
PV15,000
N4
PMT8,000

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

SolveforI

IRR39.08%

ProjectBoardShorts
PV25,000
N5
PMT12,000
SolveforI
IRR38.62%
BasedonIRRanalysis,BillabongTechshouldchooseprojectTShirt.
E85:
Answer:

NPV
Note:TheIRRforProjectTerrais10.68%whilethatofProjectFirmais10.21%.Furthermore,
whenthediscountrateiszero,thesumofProjectTerrascashflowsexceedthatofProject
Firma.Hence,atanydiscountratethatproducesapositiveNPV,ProjectTerraprovidesthe
highernetpresentvalue.

Chapter8CapitalBudgetingTechniques

Solutions to Problems
Notetoinstructor:InmostproblemsinvolvingtheIRRcalculation,afinancialcalculatorhasbeenused.
P81.

Paybackperiod
a. $42,000$7,0006years
b. Thecompanyshouldaccepttheproject,since68.

P82.

Paybackcomparisons
a.

Machine1:$14,000$3,0004years,8months
Machine2:$21,000$4,0005years,3months
b. OnlyMachine1hasapaybackfasterthan5yearsandisacceptable.
c. Thefirmwillacceptthefirstmachinebecausethepaybackperiodof4years,8monthsis
lessthanthe5yearmaximumpaybackrequiredbyNovaProducts.
d. Machine2hasreturnsthatlast20yearswhileMachine1hasonlysevenyearsofreturns.
Paybackcannotconsiderthisdifference;itignoresallcashinflowsbeyondthepayback
period.Inthiscase,thetotalcashflowfromMachine1is$59,000($80,000$21,000)less
thanMachine2.
P83.

Choosingbetweentwoprojectswithacceptablepaybackperiods
a.
ProjectA
Year
0
1
2
3
4
5

Cash
Inflows
$10,000
20,000
30,000
40,000
20,000

Investment
Balance
$100,000
90,000
70,000
40,000
0

ProjectB
Year

Cash
Inflows

0
1
2
3
4
5

40,000
30,000
20,000
10,000
20,000

Investment
Balance
$100,000
60,000
30,000
10,000
0

BothProjectAandProjectBhavepaybackperiodsofexactly4years.
b. Basedontheminimumpaybackacceptancecriteriaof4yearssetbyFaisalAlMahroos,both
projectsshouldbeaccepted.However,sincetheyaremutuallyexclusiveprojects,Faisal
shouldacceptProjectB.
c. ProjectBispreferredoverAbecausethelargercashflowsareintheearlyyearsofthe
project.Thequickercashinflowsoccur,thegreatertheirvalue.

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

P84.

NPVforvaryingcostofcapital
PVnPMT(PVIFAk%,8yrs.)
a.

10%
PVn$5,000(5.335)
PVn$26,675
NPVPVnInitialinvestment
NPV$26,675$24,000
NPV$2,675
Calculatorsolution:$2,674.63
Accept;positiveNPV

b. 12%
PVn$5,000(4.968)
PVn$24,840
NPVPVnInitialinvestment
NPV$24,840$24,000
NPV$840
Calculatorsolution:$838.20
Accept;positiveNPV
c.

14%
PVn$5,000(4.639)
PVn$23,195
NPVPVnInitialinvestment
NPV$23,195$24,000
NPV$805
Calculatorsolution:$805.68
Reject;negativeNPV

P85.

NPVindependentprojects
ProjectA
N = 10, I = 14%, PMT = $4,000
Solve for PV = $20,864.46
NPV = $20,864.46 $26,000
NPV= $5,135.54
Reject
ProjectBPVofCashInflows
CF0=$500,000;CF1=$100,000;CF2=$120,000;CF3=$140,000;CF4=$160,000;
CF5=$180,000;CF6=$200,000
SetI=14%
SolveforNPV=$53,887.93
Accept

Chapter8CapitalBudgetingTechniques

ProjectCPVofCashInflows
CF0=$170,000;CF1=$20,000;CF2=$19,000;CF3=$18,000;CF4=$17,000;
CF5=$16,000;CF6=$15,000;CF7=$14,000;CF8=$13,000;CF9=$12,000;CF10=
$11,000,
SetI=14%
SolveforNPV=$83,668.24
Reject
ProjectD
N=8,I=14%,PMT=$230,000
SolveforPV=$1,066,939
NPV=PVnInitialinvestment
NPV=$1,066,939$950,000
NPV=$116,939
Accept
ProjectEPVofCashInflows
CF0=$80,000;CF1=$0;CF2=$0;CF3=$0;CF4=$20,000;CF5=$30,000;CF6=$0;
CF7=$50,000;CF8=$60,000;CF9=$70,000
SetI=14%
SolveforNPV=$9,963.63
Accept
P86.

NPV
N = 5, I = 9%, PMT = $385,000
Solve for PV = $1,497,515.74
The immediate payment of $1,500,000 is not preferred because it has a higher present value
than does the annuity.
b. N = 5, I = 9%, PV = $1,500,000
Solve for PMT = $385,638.69
c. Present valueAnnuity Due = PVordinary annuity (1 + discount rate)
$1,497,515.74 (1.09) = $1,632,292
Calculatorsolution:$1,632,292
ChangingtheannuitytoabeginningoftheperiodannuityduewouldcauseSalim
Innovationstopreferthe$1,500,000onetimepaymentsincethePVoftheannuitydueis
greaterthanthelumpsum.
d. No,thecashflowsfromtheprojectwillnotinfluencethedecisiononhowtofundtheproject.
Theinvestmentandfinancingdecisionsareseparate.
a.

P879. NPVandmaximumreturn
a.

N = 4, I = 10%, PMT = $4,000

Solve for PV = $12,679.46
NPV = PV Initial investment
NPV = $12,679.46 $13,000
NPV = $320.54

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

b.

Reject this project due to its negative NPV.

N = 4, PV= -$13,000, PMT = $4,000
SolveforI= 8.86%
8.86%isthemaximumrequiredreturnthatthefirmcouldhavefortheprojecttobe
acceptable.Sincethefirmsrequiredreturnis10%thecostofcapitalisgreaterthanthe
expectedreturnandtheprojectisrejected.

P88.

NPVmutuallyexclusiveprojects
a.andb.
Press A
CF0 = -$85,000; CF1 = $18,000; F1 = 8
Set I = 15%
Solve for NPV = -$4,228.21
Reject
Press B
CF0 = -$60,000; CF1 = $12,000; CF2 = $14,000; CF3 = $16,000; CF4 = $18,000;
CF5 = $20,000; CF6 = $25,000
Set I = 15%
Solve for NPV = $2,584.34
Accept
Press C
CF0 = -$130,000; CF1 = $50,000; CF2 = $30,000; CF3 = $20,000; CF4 = $20,000;
CF5 = $20,000; CF6 = $30,000; CF7 = $40,000; CF8 = $50,000
Set I = 15%
Solve for NPV = $15,043.89
Accept
c.

RankingusingNPVascriterion
Rank

Press

1
2
3
P89.

C
B
A

NPV
$15,043.89
2,584.34
4,228.21

PaybackandNPV
a.

Project
A
B
C

b.

PaybackPeriod
$40,000$13,0003.08years
3($10,000$16,000)3.63years
2($5,000$13,000)2.38years

ProjectC,withtheshortestpaybackperiod,ispreferred.
Project
A

PVn$13,0003.274
PVn$42,562
PV$42,562$40,000
NPV$2,562

Chapter8CapitalBudgetingTechniques

Calculatorsolution:$2,565.82
B
Year
1
2
3
4
5

CF

PVIF16%,n

PV

$7,000
10,000
13,000
16,000
19,000

0.862
0.743
0.641
0.552
0.476

$6,034
7,430
8,333
8,832
9,044
$39,673

NPV$39,673$40,000
NPV$327
Calculatorsolution:$322.53
C
Year
1
2
3
4
5

CF

PVIF16%,n

PV

$19,000
16,000
13,000
10,000
7,000

0.862
0.743
0.641
0.552
0.476

$16,378
11,888
8,333
5,520
3,332
$45,451

NPV$45,451$40,000
NPV$5,451
Calculatorsolution:$5,454.17
ProjectCispreferredusingtheNPVasadecisioncriterion.
c.

Atacostof16%,ProjectChasthehighestNPV.BecauseofProjectCscashflow
characteristics,highearlyyearcashinflows,ithasthelowestpaybackperiodandthe
highestNPV.

P810. Internalrateofreturn
IRRisfoundbysolving:
CFt
initialinvestment
t
t 1 (1 IRR)
n

$0

ItcanbecomputedtothenearestwholepercentbytheestimationmethodasshownforProjectA
beloworbyusingafinancialcalculator.(SubsequentIRRproblemshavebeensolvedwitha
financialcalculatorandroundedtothenearestwholepercent.)
ProjectA
Averageannuity($20,000$25,00030,000$35,000$40,000)5
Averageannuity$150,0005
Averageannuity$30,000

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

PVIFAk%,5yrs.$90,000$30,0003.000
PVIFA19%,5yrs.3.0576
PVlFA20%,5yrs.2.991
However,try17%and18%sincecashflowsaregreaterinlateryears.

Yeart
1
2
3
4
5

CFt
(1)

PVIF17%,t
(2)

$20,000
25,000
30,000
35,000
40,000

0.855
0.731
0.624
0.534
0.456

Initialinvestment
NPV

PV@17%
[(1)(2)]
(3)
$17,100
18,275
18,720
18,690
18,240

$91,025
90,000
$1,025

PVIF18%,t
(4)
0.847
0.718
0.609
0.516
0.437

PV@18%
[(1)(4)]
(5)
$16,940
17,950
18,270
18,060
17,480

$88,700
90,000
$1,300

NPVat17%iscloserto$0,soIRRis17%.Ifthefirmscostofcapitalisbelow17%,theproject
wouldbeacceptable.
Calculatorsolution:17.43%
ProjectB
PVn PMT(PVIFAk%,4yrs.)
$490,000$150,000(PVIFAk%,4yrs.)
$490,000$150,000(PVIFAk%,4yrs.)
3.27PVIFAk%,4
8%IRR9%
Calculatorsolution:IRR8.62%
Thefirmsmaximumcostofcapitalforprojectacceptabilitywouldbe8%(8.62%).
ProjectC
PVnPMT(PVIFAk%,5yrs.)
$20,000$7,500(PVIFAk%,5yrs.)
$20,000$7,500(PVIFAk%,5yrs.)
2.67PVIFAk%,5yrs.
25%IRR26%
Calculatorsolution:IRR25.41%
Thefirmsmaximumcostofcapitalforprojectacceptabilitywouldbe25%(25.41%).
ProjectD
$0

$120,000 $100,000
$80,000
$60,000

$240,000
1
2
3
(1 IRR) (1 IRR) (1 IRR) (1 IRR) 4

IRR21%;Calculatorsolution:IRR21.16%
Thefirmsmaximumcostofcapitalforprojectacceptabilitywouldbe21%(21.16%).

Chapter8CapitalBudgetingTechniques

P811. IRR,investmentlife,andcashinflows
a.

PVnPMT(PVIFAk%,n)
$61,450$10,000(PVIFAk%,10yrs.)
$61,450$10,000PVIFAk%,10yrs.
6.145PVIFAk%,10yrs.
kIRR10%(calculatorsolution:10.0%)
TheIRRcostofcapital;rejecttheproject.
b. PVnPMT(PVIFA%,n)
$61,450$10,000(PVIFA15%,n)
$61,450$10,000PVIFA15%,n
6.145PVIFA15%,n
18yrs.n19yrs.
Calculatorsolution:18.23years
Theprojectwouldhavetorunalittleover8moreyearstomaketheprojectacceptablewith
the15%costofcapital.
c.

PVnPMT(PVIFA15%,10)
$61,450PMT(5.019)
$61,4505.019PMT
$12,243.48PMT
Calculatorsolution:$12,244.04

P812. NPVandIRR
a.

PVnPMT(PVIFA10%,7yrs.)
PVn$4,000(4.868)
PVn$19,472

NPVPVnInitialinvestment
NPV$19,472$18,250
NPV$1,222
Calculatorsolution:$1,223.68
b. PVnPMT(PVIFAk%,n)
$18,250$4,000(PVIFAk%,7yrs.)
$18,250$4,000(PVIFAk%,7yrs.)
4.563PVIFAk%,7yrs.
IRR12%
Calculatorsolution:12.01%
c. TheprojectshouldbeacceptedsincetheNPV0andtheIRRthecostofcapital.
P813. NPV,withrankings
a.

NPVA$20,000(PVIFA15%,3)$50,000
NPVA$20,000(2.283)$50,000
NPVA$45,660$50,000$4,340

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

Calculatorsolution:$4,335.50
Reject
NPVB$35,000(PVIF15%,1)$50,000(PVIFA15%,2)(PVIF15%,1)$100,000
NPVB$35,000(0.870)$50,000(1.626)(0.870)$100,000
NPVB$30,450$70,731$100,000$1,181
Calculatorsolution:$1,117.78
Accept
NPVC$20,000(PVIF15%,1)$40,000(PVIF15%,2)$60,000(PVIF15%,3)$80,000
NPVC$20,000(0.870)$40,000(0.756)$60,000(0.658)$80,000
NPVC$17,400$30,24039,480$80,000$7,120
Calculatorsolution:$7,088.02
Accept
NPVD$100,000(PVIF15%,1)$80,000(PVIF15%,2)$60,000(PVIF15%,3)
$180,000
NPVD$100,000(0.870)$80,000(0.756)$60,000(0.658)$180,000
NPVD$87,000$60,48039,480$180,000$6,960
Calculatorsolution:$6,898.99
Accept
b.
Rank
1
2
3
c.

Press
C
D
B

NPV
$7,120
6,960
1,181

UsingthecalculatortheIRRsoftheprojectsare:
Project

IRR

A
B
C
D

9.70%
15.63%
19.44%
17.51%

SincethelowestIRRis9.7%alloftheprojectswouldbeacceptableifthecostofcapital
was9.7%.
NOTE:SinceProjectAwastheonlyrejectprojectfromthefourprojects,allthatwas
neededtofindtheminimumacceptablecostofcapitalwastofindtheIRRofA.
P814. Alltechniques,conflictingrankings

Chapter8CapitalBudgetingTechniques

a.

Year
0
1
2
3
4
5
6

ProjectA
Cash
Investment
Inflows
Balance
$45,000
45,000
45,000
45,000
45,000
45,000

Payback A

$150,000
105,000
60,000
15,000
30,000

Year
0
1
2
3
4

ProjectB
Cash
Investment
Inflows
Balance
$75,000
60,000
30,000
30,000
30,000
30,000

$150,000
75,000
15,000
15,000
0

$150,000
3.33years 3years4months
$45,000

Payback B 2years

$15,000
years 2.5years 2years6months
$30,000

b. NPVA$45,000(PVIFA0%,6)$150,000
NPVA$45,000(6)$150,000
NPVA$270,000$150,000$120,000
Calculatorsolution:$120,000
NPVB$75,000(PVIF0%,1)$60,000(PVIF0%,2)$30,000(PVIFA0%,4)(PVIF0%,2)
$150,000
NPVB$75,000$60,000$30,000(4)$150,000
NPVB$75,000$60,000$120,000$150,000$105,000
Calculatorsolution:$105,000
c.

NPVA$45,000(PVIFA9%,6)$150,000
NPVA$45,000(4.486)$150,000
NPVA$201,870$150,000$51,870
Calculatorsolution:$51,886.34
NPVB$75,000(PVIF9%,1)$60,000(PVIF9%,2)$30,000(PVIFA9%,4)(PVIF9%,2)
$150,000
NPVB$75,000(0.917)$60,000(0.842)$30,000(3.24)(0.842)$150,000
NPVB$68,775$50,520$81,842$150,000$51,137
Calculatorsolution:$51,112.36

d. Usingafinancialcalculator:
IRRA19.91%
IRRB22.71%

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

e.

Project

Payback

Rank
NPV

IRR

2
1

1
2

2
1

A
B

TheprojectthatshouldbeselectedisA.TheconflictbetweenNPVandIRRisduepartially
tothereinvestmentrateassumption.TheassumedreinvestmentrateofProjectBis22.71%,
theprojectsIRR.ThereinvestmentrateassumptionofAis9%,thefirmscostofcapital.On
apracticallevelProjectBwillprobablybeselectedduetomanagementspreferencefor
makingdecisionsbasedonpercentagereturns,andtheirdesiretoreceiveareturnofcash
quickly.
P815. NPV,IRR,andNPVprofiles
a.andb.
ProjectA
PVofcashinflows:
Year
1
2
3
4
5

CF
$25,000
35,000
45,000
50,000
55,000

PVIF12%,n
0.893
0.797
0.712
0.636
0.567

PV
$22,325
27,895
32,040
31,800
31,185
$145,245

NPVPVofcashinflowsinitialinvestment
NPV$145,245$130,000
NPV$15,245
Calculatorsolution:$15,237.71
BasedontheNPVtheprojectisacceptablesincetheNPVisgreaterthanzero.
$0

$25,000
$35,000
$45,000
$50,000
$55,000

$130,000
(1 IRR)1 (1 IRR)2 (1 IRR)3 (1 IRR) 4 (1 IRR)5

IRR16%
Calculatorsolution:16.06%
BasedontheIRRtheprojectisacceptablesincetheIRRof16%isgreaterthanthe12%cost
ofcapital.
ProjectB
PVofcashinflows:
Year
1
2
3

CF

PVIF12%,n

PV

$40,000
35,000
30,000

0.893
0.797
0.712

$35,720
27,895
21,360

Chapter8CapitalBudgetingTechniques

4
5

10,000
5,000

0.636
0.567

6,360
2,835
$94,170

NPV$94,170$85,000
NPV$9,170
Calculatorsolution:$9,161.79
BasedontheNPVtheprojectisacceptablesincetheNPVisgreaterthanzero.
$0

$40,000
$35,000
$30,000
$10,000
$5,000

$85,000
1
2
3
4
(1 IRR) (1 IRR) (1 IRR) (1 IRR)
(1 IRR)5

IRR18%
Calculatorsolution:17.75%
BasedontheIRRtheprojectisacceptablesincetheIRRof16%isgreaterthanthe12%cost
ofcapital.
c.

DataforNPVProfiles
NPV
DiscountRate
0%
12%
15%
16%
18%

A
$80,000
$15,245

B
$35,000

$9,170

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

d. Thenetpresentvalueprofileindicatesthatthereareconflictingrankingsatadiscountrate
lessthantheintersectionpointofthetwoprofiles(approximately15%).Theconflictin
rankingsiscausedbytherelativecashflowpatternofthetwoprojects.Atdiscountrates
aboveapproximately15%,ProjectBispreferable;belowapproximately15%,ProjectAis
better.BasedonCandorEnterprises12%costofcapital,ProjectAshouldbechosen.
e. ProjectAhasanincreasingcashflowfromYear1throughYear5,whereasProjectBhasa
decreasingcashflowfromYear1throughYear5.Cashflowsmovinginoppositedirections
oftencauseconflictingrankings.TheIRRmethodreinvestsProjectBslargerearlycash
flowsatthehigherIRRrate,notthe12%costofcapital.
P816. Alltechniquesdecisionamongmutuallyexclusiveinvestments

Cashinflows(years15)
a. Payback*
b. NPV*
c.

IRR*

A
$20,00
0
3years
$10,34
0
20%

Project
B
$31,500

C
$32,500

3.2years
$10,786

3.4years
$4,303

17%

Supportingcalculationsshownbelow:

a.

PaybackPeriod: ProjectA:$60,000$20,000 3years

ProjectB:$100,000$31,500 3.2years
ProjectC:$110,000$32,500 3.4years

b. NPV
ProjectA
PVnPMT(PVIFA13%,5yrs.)
PVn$20,0003.517
PVn70,340
NPV$70,340$60,000
NPV$10,340
Calculatorsolution:$10,344.63
ProjectB
PVn$31,500.003.517
PVn$110,785.50
NPV$110,785.50$100,000
NPV$10,785.50
Calculatorsolution:$10,792.78
ProjectC
PVn$32,500.003.517
PVn$114,302.50
NPV$114,302.50$110,000
NPV$4,302.50

15%

Chapter8CapitalBudgetingTechniques

Calculatorsolution:$4,310.02
c.

IRR
Project,A
NPVat19%$1,152.70
NPVat20%$187.76
SinceNPVisclosertozeroat20%,IRR20%
Calculatorsolution:19.86%
ProjectB
NPVat17%$779.40
NPVat18%$1,494.11
SinceNPVisclosertozeroat17%,IRR17%
Calculatorsolution:17.34%
ProjectC
NPVat14%$1,575.13
NPVat15%$1,054.96
SinceNPVisclosertozeroat15%,IRR15%
Calculatorsolution:14.59%

d.

DataforNPVProfiles
NPV
DiscountRate

0%

$40,00
0

$57,500

$52,500

13%

$10,34
0

10,786

4,303

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

15%

17%

20%

ThedifferenceinthemagnitudeofthecashflowforeachprojectcausestheNPVtocompare
favorablyorunfavorably,dependingonthediscountrate.
e.

EventhoughArankshigherinPaybackandIRR,financialtheoristswouldarguethatBis
superiorsinceithasthehighestNPV.AdoptingBadds$445.50moretothevalueofthefirm
thandoesA.

P817. AlltechniqueswithNPVprofilemutuallyexclusiveprojects
a.

ProjectA
Paybackperiod
Year1Year2Year3 $60,000
Year4
$20,000
Initialinvestment
$80,000
Payback3years($20,00030,000)
Payback3.67years
ProjectB
Paybackperiod
$50,000$15,0003.33years

b. ProjectA
PVofcashinflows
Year
1
2
3
4
5

CF
$15,000
20,000
25,000
30,000
35,000

PVIF13%,n
0.885
0.783
0.693
0.613
0.543

PV
$13,275
15,660
17,325
18,390
19,005

$83,655

Chapter8CapitalBudgetingTechniques

NPVPVofcashinflowsinitialinvestment
NPV$83,655$80,000
NPV$3,655
Calculatorsolution:$3,659.68
ProjectB
NPVPVofcashinflowsinitialinvestment
PVnPMT(PVIFA13%,n)
PVn$15,0003.517
PVn$52,755
NPV$52,755$50,000
NPV$2,755
Calculatorsolution:$2,758.47
c.

ProjectA
$0

$15,000
$20,000
$25,000
$30,000
$35,000

$80,000
(1 IRR)1 (1 IRR)2 (1 IRR)3 (1 IRR)4 (1 IRR)5

IRR15%
Calculatorsolution:14.61%
ProjectB
$0$15,000(PVIFAk%,5)$50,000
IRR15%
Calculatorsolution:15.24%
d.

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

DataforNPVProfiles
NPV
DiscountRate
A
0%
13%
14.6%
15.2%

$45,000
$3,655
0

B
$25,000
2,755

Intersectionapproximately14%
Ifcostofcapitalisabove14%,conflictingrankingsoccur.
Thecalculatorsolutionis13.87%.
e.

Bothprojectsareacceptable.Bothhavesimilarpaybackperiods,positiveNPVs,and
equivalentIRRsthataregreaterthanthecostofcapital.AlthoughProjectBhasaslightly
higherIRR,theratesareveryclose.SinceProjectAhasahigherNPVacceptProjectA.

P818 NPVandEVA
a. NPV = $2,500,000 + $240,000 0.09 = $166,667
b. Annual EVA = $240,000 ($2,500,000 x 0.09) = $15,000
c. Overall EVA = $15,000 0.09 = $166,667
Inthiscase,NPVandEVAgiveexactlythesameanswer.
P819 IntegrativeConflictingrankings
a.

Plant Expansion
CF0 = $3,500,000, CF1 = 1,500,000, CF2 = $2,000,000, CF3 = $2,500,000, CF4 =
$2,750,000
Set I = 20%; Solve for NPV = $1,911,844.14
Solve for IRR = 43.70%
CF1 = 1,500,000, CF2 = $2,000,000, CF3 = $2,500,000, CF4 = $2,750,000
Set I = 20%; Solve for NPV = $5,411,844.14 (This is the PV of the cash inflows)
PI = $5,411,844.14 $3,500,000 = 1.55
Product Introduction
CF0 = $500,000, CF1 = 250,000, CF2 = $350,000, CF3 = $375,000, CF4 =
$425,000
Set I = 20%; Solve for NPV = $373,360.34
Solve for IRR = 52.33%
CF1 = 250,000, CF2 = $350,000, CF3 = $375,000, CF4 = $425,000
Set I = 20%; Solve for NPV = $873,360.34 (This is the PV of the cash inflows)
PI = $873,360.34 $500,000 = 1.75

b.
Project
Plant Expansion
Product Introduction
c.

NPV
1
2

Rank
IRR
2
1

PI
2
1

The NPV is higher for the plant expansion, but both the IRR and the PI are higher for the
product introduction project. The rankings do not agree because the plant expansion has a
much larger scale. The NPV recognizes that it is better to accept a lower return on a larger

Chapter8CapitalBudgetingTechniques

d.

project here. The IRR and PI methods simply measure the rate of return on the project and not
its scale (and therefore not how much money in total the firm makes from each project).
Because the NPV of the plant expansion project is higher, the firms shareholders would be
better off if the firm pursued that project, even though it has a lower rate of return.

P820. Ethicsproblem
ExpensesarealmostsuretoincreaseforGap.Thestockpricewouldalmostsurelydeclineinthe
immediatefuture,ascashexpensesriserelativetocashrevenues.Inthelongrun,Gapmaybe
abletoattractandretainbetteremployees,newhumanrightsandenvironmentallyconscious
customers,andnewinvestordemandfromtheburgeoningsociallyresponsibleinvestingmutual
funds.Thislongruneffectisnotassured,andweareagainremindedthatitsnotmerely
shareholderwealthmaximizationwereafterbutmaximizingshareholderwealthsubjectto
ethicalconstraints.
Infact,ifGapwasunwillingtorenegotiateworkerconditions,CalvertGroup(andothers)might
sellGapsharesandtherebydecreaseshareholderwealth.

MyFinanceLab
Furtherchapterrelevantproblemsandassignmentscanbefoundatthebooksaccompanyingresource:
MyFinanceLab.Gotowww.myfinancelab.com.

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

Case
Making Halwan Tools Lathe Investment Decision
ThestudentisfacedwithatypicalcapitalbudgetingsituationinChapter8scase.HalwanToolmust
selectoneoftwolathesthathavedifferentinitialinvestmentsandcashinflowpatterns.Aftercalculating
bothunsophisticatedandsophisticatedcapitalbudgetingtechniques,thestudentmustreevaluatethe
decisionbytakingintoaccountthehigherriskofonelathe.
a. Paybackperiod
LatheA:
Years14
$644,000
Payback4years($16,000$450,000) 4.04years
LatheB:
Years13
$304,000
Payback3years($56,000$86,000) 3.65years
LatheAwillberejectedsincethepaybackislongerthanthe4yearmaximumaccepted,andLatheB
isacceptedbecausetheprojectpaybackperiodislessthanthe4yearpaybackcutoff.
b.
1) NPV
Year

LatheA
CashFlow

PVIF13%

$128,000

0.885

2
3
4
5

182,000
166,000
168,000
450,000

0.783
0.693
0.613
0.543

PV
$113,28
0
142,506
115,038
102,984
244,350

PV
NPVA$718,158$660,000
$58,158
Calculatorsolution:$58,132.88

LatheB
CashFlow

PVIF13%,t

$88,000

0.885

120,000
96,000
86,000
207,000

0.783
0.693
0.613
0.543

718,15
8

PV

NPVB$403,487$360,000
$43,487
Calculatorsolution:$43,483.24

2) IRR
LatheA
$0

$128,000 $182,000 $166,000 $168,000 $450,000

$660,000
(1 IRR)1 (1 IRR)2 (1 IRR)3 (1 IRR) 4 (1 IRR)5

IRR16%

PV
$
77,880
93,960
66,528
52,718
112,40

1
$403,48
7

Chapter8CapitalBudgetingTechniques

Calculatorsolution:15.95%
LatheB
$0

$88,000
$120,000
$96,000
$86,000
$207,000

$360,000
1
2
3
4
(1 IRR) (1 IRR) (1 IRR) (1 IRR)
(1 IRR)5

IRR17%
Calculatorsolution:17.34%
UndertheNPVrulebothlathesareacceptablesincetheNPVsforAandBaregreaterthanzero.
LatheAranksaheadofBsinceithasalargerNPV.Thesameacceptdecisionappliestoboth
projectswiththeIRR,sincebothIRRsaregreaterthanthe13%costofcapital.However,the
rankingreverseswiththe17%IRRforBbeinggreaterthanthe16%IRRforLatheA.
c. Summary
Paybackperiod
NPV
IRR

LatheA

LatheB

4.04years
$58,158
16%

3.65years
$43,487

BothprojectshavepositiveNPVsandIRRsabovethefirmscostofcapital.LatheA,however,
exceedsthemaximumpaybackperiodrequirement.Becauseitissoclosetothe4yearmaximum
andthisisanunsophisticatedcapitalbudgetingtechnique,LatheAshouldnotbeeliminatedfrom
considerationonthisbasisalone,particularlysinceithasamuchhigherNPV.
Ifthefirmhasunlimitedfunds,itshouldchoosetheprojectwiththehighestNPV,LatheA,inorder
tomaximizeshareholdervalue.Ifthefirmissubjecttocapitalrationing,LatheB,withitsshorter
paybackperiodandhigherIRR,shouldbechosen.TheIRRconsiderstherelativesizeofthe
investment,whichisimportantinacapitalrationingsituation.
d. TocreateanNPVprofileitisbesttohaveatleast3NPVdatapoints.Tocreatethethirdpointan8%
discountratewasarbitrarilychosen.Withthe8%ratetheNPVforLatheAis$176,077andtheNPV
forLatheBis$104,663

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

LatheBispreferredoverLatheAbasedontheIRR.However,ascanbeseenintheNPVprofile,to
theleftofthecrossoverpointofthetwolinesLatheAispreferred.Theunderlyingcauseofthis
conflictinrankingsarisesfromthereinvestmentassumptionofNPVversusIRR.NPVassumesthe
intermediatecashflowsarereinvestedatthecostofcapital,whiletheIRRhascashflowsbeing
reinvestedattheIRR.Thedifferenceinthesetworatesandthetimingofthecashflowswill
determinethecrossoverpoint.
e. OnatheoreticalbasisLatheAshouldbepreferredbecauseofitshigherNPVandthusitsknown
impactonshareholderwealth.FromapracticalperspectiveLatheBmaybeselectedduetoitshigher
IRRanditsfasterpayback.Thisdifferenceresultsfrommanagerspreferenceforevaluatingdecisions
basedonpercentreturnsratherthandollarreturns,andonthedesiretogetareturnofcashflowsas
quicklyaspossible.

Spreadsheet Exercise
TheanswertoChapter8sDrillagoCompanyspreadsheetproblemislocatedinMyFinanceLab:
www.myfinancelab.com

In Their Own Words

Harnessing the Power of the Sun
Efforts to harness the power of the sun and meet rising energy needs have intensified in recent decades. In
addition to the billions of dollars that have been currently spend on research and development and other
scientific applications, billions more are needed to support solar power projects and produce affordable
and low costs energy alternatives. Students of finance should discuss the financial feasibility of
undertaking such investment and the potential prospects of finding new sources of energy to substitute for
increasingly costly non-renewable resources. Indicators suggest that energy industries are increasing cost
industries. Why are energy industries increasing cost industries? Are current expenditures on investment to
develop new sources of energy justified in the long run?