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Capital-Budgeting Techniques

and Practice

CHAPTER ORIENTATION

Capital budgeting involves the decision-making process with respect to investment in fixed

assets; specifically, it involves measuring the incremental cash flows associated with investment

proposals and evaluating the attractiveness of these cash flows relative to the project’s costs.

This chapter focuses on the various decision criteria. It also examines how to deal with

complications in the capital budgeting process including mutually exclusive projects and capital

rationing.

CHAPTER OUTLINE

A. The payback period method

1. The payback period of an investment tells the number of years required to

recover the initial investment. The payback period is calculated by adding

up the cash flows until they are equal to the initial fixed investment.

2. Although this measure does, in fact, deal with cash flows and is easy to

calculate and understand, it ignores any cash flows that occur after the

payback period and does not consider the time value of money within the

payback period.

B. Present-value methods

1. The net present value of an investment project is the present value of the

cash inflows less the present value of the cash outflows. By assigning

negative values to cash outflows, it becomes

n

FCFt

NPV = ∑ (1 + k )

t =1

t

- IO

where FCFt = the annual free cash flow in time period t (this can

take on either positive or negative values)

274

k = the required rate of return or appropriate discount

rate or cost of capital

IO = the initial cash outlay

n = the project’s expected life

a. The acceptance criteria are:

accept if NPV ≥ 0

b. The advantage of this approach is that it takes the time value of

money into consideration in addition to dealing with cash flows.

2. The profitability index is the ratio of the present value of the expected

future net cash flows to the initial cash outlay, or

n

FCFt

∑ (1 + k )

t −1

t

profitability index =

IO

a. The acceptance criteria are:

accept if PI ≥ 1.0

reject if PI < 1.0

b. The advantages of this method are the same as those for the net

present value.

c. Either of these present-value methods will give the same accept-

reject decisions to a project.

C. The internal rate of return is the discount rate that equates the present value of the

project’s future net cash flows with the project’s initial outlay. Thus, the internal

rate of return is represented by IRR in the equation below:

n

FCFt

IO = ∑ (1 +

t =1 IRR )

t

accept if IRR ≥ required rate of return

reject if IRR < required rate of return

The required rate of return is often taken to be the firm’s cost of capital.

2. The advantages of this method are that it deals with cash flows and

recognizes the time value of money; however, the procedure is rather

complicated and time-consuming.

3. One disadvantage is that the IRR implicitly assumes cash flows received

over the project’s life can be reinvested at the IRR.

275

D. The MIRR is similar to the IRR except it relies on the assumption that all free

cash flows over the life of the project are reinvested at the required rate of return

until the termination of the project. Thus, to calculate the MIRR, we:

Step 1: Determine the present value of the project’s free cash outflows. We do

this by discounting all the free cash outflows, back to the present at the required

rate of return. If the initial outlay is the only free cash outflow, then the initial

outlay is the present value of the free cash outflows.

Step 2: Determine the present value of the project’s free cash inflows. Take all the

annual free cash inflows and find their future value at the end of the project’s life,

compounded forward at the required rate of return. We will call this the project’s

terminal value, or TV.

Step 3: Calculate the MIRR. The MIRR is the discount rate that equates the

present value of the free cash outflows with the present value of the project’s

terminal value.

1. The modified internal rate of return is defined as the value of MIRR in the

following equation:

PVoutflows = TVinflows (9-4)

n

(1 + MIRR)

Where PVoutflows = the present value of the project’s free cash outflows

TVinflows = the project’s terminal value, calculated by taking all the annual free

cash inflows and find their future value at the end of the project’s life,

compounded forward at the required rate of return

n = the project’s expected life

MIRR = the project’s modified internal rate of return

E. The easiest way to understand the relationship between the IRR and the NPV is to

view it graphically through the use of a net present value profile. A net present

value profile is simply a graph showing how a project’s NPV changes as the

discount rate changes. From the net present value profile you can easily see how

a project’s NPV varies inversely with the discount rate, and you can also see how

sensitive the project is to your selection of the discount rate.

II. Mutually exclusive projects: Although the IRR and the present-value methods will, in

general, give consistent accept-reject decisions, they may not rank projects identically.

This becomes important in the case of mutually exclusive projects.

A. A project is mutually exclusive if acceptance of it precludes the acceptance of one

or more projects. Then, in this case, the project’s relative ranking becomes

important.

B. Ranking conflicts come as a result of the different assumptions about the

reinvestment rate of funds released from the proposals.

276

C. Thus, when conflicting ranking of mutually exclusive projects results from the

different reinvestment assumptions, the decision boils down to which assumption

is best.

D. In general, the net present value method is considered to be theoretically superior.

III. Capital rationing is the situation in which a budget ceiling or constraint is placed upon the

amount of funds that can be invested during a time period.

A. Theoretically, a firm should never reject a project that yields more than the required

rate of return. Although there are circumstances that may create complicated

situations in general, an investment policy limited by capital rationing is less than

optimal.

IV. Without question the key to success in capital budgeting is identifying good projects, and

for many companies these good projects are overseas. In fact, Coca-Cola, Xerox,

Hewlett-Packard, and IBM all earn more than 50% of their profits from abroad.

ANSWERS TO

END-OF-CHAPTER QUESTIONS

9-1. Capital-budgeting decisions involve investments requiring rather large cash outlays at the

beginning of the life of the project and commit the firm to a particular course of action

over a relatively long time horizon. As such, they are both costly and difficult to reverse,

both because of: (1) their large cost and (2) the fact that they involve fixed assets which

cannot be liquidated easily.

9-2. The criticisms of using the payback period as a capital-budgeting technique are:

1. It ignores the timing of the flows that occur during the payback period.

2. It ignores all flows occurring after the payback period.

The advantages associated with the payback period are:

1. It deals with cash flows rather than accounting profits and, therefore, focuses on

the true timing of the project’s benefits and costs.

2. It is easy to calculate and understand.

3. It can be used as a rough screening device, eliminating projects whose returns do

not materialize until later years.

These final two advantages are the major reasons why it is used frequently.

9-3. Yes. The payback period eliminates projects whose returns do not materialize until later

years and, thus, emphasizes the earliest returns, which in a country experiencing frequent

expropriations would certainly have the most amount of uncertainty surrounding them.

In this case, the payback period could be used as a rough screening device to filter out

those riskier projects, which have long lives.

277

9-4. The three discounted cash flow capital, budgeting criteria are the net present value, the

profitability index, and the internal rate of return. The net present value method gives an

absolute dollar value for a project by taking the present value of the benefits and

subtracting the present value of the costs. The profitability index compares these benefits

and costs through division and comes up with a measure of the project’s relative value—a

benefit/cost ratio. On the other hand, the internal rate of return tells us the rate of return

that the project earns. In the capital-budgeting area, these methods generally give us the

same accept-reject decision on projects but many times rank them differently. As such,

they have the same general advantages and disadvantages, although the calculations

associated with the internal rate of return method can become quite tedious. The

advantages associated with these discounted cash flow methods are:

1. They deal with cash flows rather than accounting profits.

2. They recognize the time value of money.

3. They are consistent with the firm’s goal of shareholder wealth maximization.

9-5. Mutually exclusive projects involve two or more projects where the acceptance of one

project will necessarily mean the rejection of the other project. This usually occurs when

the set of projects perform essentially the same task. Relating this to our discounted cash

flow criteria, it means that not all projects with positive NPVs, profitability indexes

greater than 1.0, and IRRs greater than the required rate of return will be accepted.

Moreover, since our discounted cash flow criteria do not always yield the same ranking

of projects, one criterion may indicate that the mutually exclusive project A should be

accepted, while another criterion may indicate that the mutually exclusive project B

should be accepted.

9-6. There are three principal reasons for imposing a capital-rationing constraint. First, the

management may feel that market conditions are temporarily adverse. In the early- and

mid-seventies, this reason was fairly common, because interest rates were at an all-time

high and stock prices were at a depressed level. The second reason is a manpower

shortage; that is, there is shortage of qualified managers to direct new projects. The final

reason involves intangible considerations. For example, the management may simply

fear debt and so will avoid interest payments at any cost. Or the common stock issuance

may be limited in order to allow the current owners to maintain strict voting control over

the company or to maintain a stable dividend policy.

Whether or not this is a rational move depends upon the extent of the rationing. If it is

minor and noncontinuing, then the firm’s share price will probably not suffer to any great

extent. However, it should be emphasized that capital rationing and rejection of projects

with positive net present values is contrary to the firm’s goal of maximization of

shareholders’ wealth.

9-7. When two mutually exclusive projects of unequal size are compared, the firm should

select the project or set of projects with the largest net present value, whether there is

capital rationing or not.

278

9-8. The time disparity problem and the conflicting rankings that accompany it result from the

differing reinvestment assumptions made by the net present value and internal rate of

return decision criteria. The net present value criterion assumes that cash flows over the

life of the project can be reinvested at the required rate of return; the internal rate of

return implicitly assumes that the cash flows over the life of the project can be reinvested

at the internal rate of return.

9-9. The problem of incomparability of projects with different lives is not directly a result of

the projects having different lives but of the fact that future profitable investment

proposals are being affected by the decision currently being made. Again the key is:

"Does the investment decision being made today affect future profitable investment

proposals?" If so, the projects are not comparable. While the most theoretically proper

approach is to make assumptions as to investment opportunities in the future, this method

is probably too difficult to be of any value in most cases. Thus, the most common

method used to deal with this problem is the creation of a replacement chain to equalize

life spans. In effect, the reinvestment opportunities in the future are assumed to be

similar to the current ones.

SOLUTIONS TO

END-OF-CHAPTER PROBLEMS

Or:

N = 8

CPT I/Y = 7

PV = -10,000

PMT = 0

FV = $17,182

Thus, IRR = 7%

b. $10,000 = $48,077 [PVIFIRR%,10 yrs]

279

Or:

N = 10

CPT I/Y = 17

PV = -10,000

PMT = 0

FV = $48,077

c. $10,000 = $114,943 [PVIFIRR%,20 yrs]

Or:

N = 20

CPT I/Y = 13

PV = -10,000

PMT = 0

FV = $114,943

d. $10,000 = $13,680 [PVIFIRR%,3 yrs]

Or:

N = 3

CPT I/Y = 11

PV = -10,000

PMT = 0

FV = $13,680

9-2. a. I0 = FCFt [PVIFAIRR%,t yrs]

280

Or:

N = 10

CPT I/Y = 15

PV = -10,000

PMT = 1,993

FV = 0

b. $10,000 = $2,054 [PVIFAIRR%,20 yrs]

4.869 = PVIFAIRR%,20 yrs

Thus, IRR = 20%

Or:

N = 20

CPT I/Y = 20

PV = -10,000

PMT = 2,054

FV = 0

c. $10,000 = $1,193 [PVIFAIRR%,12 yrs]

8.382 = PVIFAIRR%,12 yrs

Thus, IRR = 6%

Or:

N = 12

CPT I/Y = 6

PV = -10,000

PMT = 1,193

FV = 0

d. $10,000 = $2,843 [PVIFAIRR%,5 yrs]

3.517 = PVIFAIRR%,5 yrs

Thus, IRR = 13%

Or:

N = 5

CPT I/Y = 13

PV = -10,000

PMT = 2,843

FV = 0

281

$2,000 $5,000 $8,000

9-3. a. $10,000 = + +

(1 + IRR )1 (1 + IRR ) 2 (1 + IRR ) 3

Try 18%

$10,000 = $2,000(0.847) + $5,000 (0.718) + $8,000 (0.609)

= $1,694 + $3,590 + $4,872

= $10,156

Try 19%

$10,000 = $2,000 (0.840) + $5,000 (0.706) + $8,000 (0.593)

= $1,680 + $3,530 + $4,744

= $9,954

Thus, IRR = approximately 19%

b. $10,000 = + +

1 2

(1 + IRR ) (1 + IRR ) (1 + IRR ) 3

Try 30%

$10,000 = $8,000 (0.769) + $5,000 (0.592) + $2,000 (0.455)

= $6,152 + $2,960 + $910

= $10,022

Try 31%

$10,000 = $8,000 (0.763) + $5,000 (0.583) + $2,000 (0.445)

= $6,104 + $2,915 + $890

= $9,909

Thus, IRR = approximately 30%

5 $2,000 $5,000

c. $10,000 = ∑ +

t = 1 (1 + IRR )

t

(1 + IRR ) 6

Try 11%

$10,000 = $2,000 (3.696) + $5,000 (0.535)

= $7,392 + $2,675

= $10,067

282

Try 12%

$10,000 = $2,000 (3.605) + $5,000 (0.507)

= $7,210 + $2,535

= $9,745

Thus, IRR = approximately 11%

6 $450,000

9-4. a. NPV = ∑ - $1,950,000

t = 1 (1 + .09)

= $2,018,700 - $1,950,000 = $68,700

$2,018,700

b. PI =

$1,950,000

= 1.0352

c. $1,950,000 = $450,000 [PVIFAIRR%,6 yrs]

d. Yes, the project should be accepted.

9-5. a. Payback Period = $80,000/$20,000 = 4 years

6 $20,000

b. NPV = ∑ - $80,000

t = 1 (1 + .10 )

t

= $87,100 - $80,000 = $7,100

$87,100

c. PI =

$80,000

= 1.0888

d. $80,000 = $20,000 [PVIFAIRR%,6 yrs]

283

6 $12,000

9-6. NPVA = ∑ - $50,000

t = 1 (1 + .12 )

t

= $49,332 - $50,000 = -$668

6 $13,000

NPVB = ∑ - $70,000

t =1 (1 + .12) t

= $13,000 (4.111) - $70,000

= $53,443 - $70,000 = -$16,557

$49,332

PIA =

$50,000

= 0.9866

$53,443

PIB =

$70,000

= 0.7635

$50,000 = $12,000 [PVIFAIRR%,6 yrs]

IRRA = 11.53%

IRRB = 3.18%

9-7. Project A:

Payback Period = 2 years + $100/$200 = 2.5 years

Project B:

Payback Period = 2 years + $2,000/$3,000 = 2.67 years

Project C:

Payback Period = 3 years + $1,000/$2,000 = 3.5 years

Projects A and B should be accepted using the payback period criteria.

284

8 $1,000,000

9-8. NPV9% = ∑ - $5,000,000

t = 1 (1 + .09 )

t

= $5,535,000 - $5,000,000 = $535,000

8 $1,000,000

NPV11% = ∑ - $5,000,000

t =1 (1 + .11)t

= $1,000,000 (5.146) - $5,000,000

= $5,146,000 - $5,000,000 = $146,000

8 $1,000,000

NPV13% = ∑ - $5,000,000

t =1 (1 + .13) t

= $1,000,000 (4.799) - $5,000,000

= $4,799,000 - $5,000,000 = -$201,000

8 $1,000,000

NPV15% = ∑ - $5,000,000

t =1 (1 + .15) t

= $4,487,000 - $5,000,000 = -$513,000

9-9. Project A:

$50,000 = + +

(1 + IRR A ) 1 (1 + IRR A ) 2 (1 + IRR A ) 3

$25,000 $30,000

+ +

(1 + IRR A ) 4

(1 + IRR A ) 5

Try 23%

$50,000 = $10,000(.813) + $15,000(.661) + $20,000(.537)

+ $25,000(.437) + $30,000(.355)

= $8,130 + $9,915 + $10,740 + $10,925 + $10,650

= $50,360

285

Try 24%

$50,000 = $10,000(.806) + $15,000(.650) +$20,000(.524)

+ $25,000(.423) + $30,000(.341)

= $8,060 + $9,750 + $10,480 + $10,575 + $10,230

= $49,095

Thus, IRR = just over 23%

Project B:

$100,000 = $25,000 [PVIFAIRR%,5 yrs]

Thus, IRR = 8%

Project C:

$450,000 = $200,000 [PVIFAIRR%,3 yrs]

10 $18,000

9-10. a. NPV = ∑ - $100,000

t =1 (1 + .10 ) t

= $18,000(6.145) - $100,000

= $110,610 - $100,000

= $10,610

10 $18,000

b. NPV = ∑ - $100,000

t =1 (1 + .15 ) t

= $18,000(5.019) - $100,000

= $90,342 - $100,000

= -$9,658

c. If the required rate of return is 10%, the project is acceptable as in part a.

d. $100,000 = $18,000 [PVIFAIRR%,10 yrs]

286

9-11. Calculator Solution (using a Texas Instruments BA-II Plus):

CF; -653,803; ENTER CF0 = -653,803.00

↓; 300,000; ENTER C01 = 300,000.00

↓; 2; ENTER F01 = 2.00

↓; 200,000; ENTER C02 = 200,000.00

↓; 1; ENTER F02 = 1.00

↓; 100,000; ENTER C03 = 100,000.00

↓; 1; ENTER F03 = 1.00

IRR; CPT IRR = 17.00

Try different discount rates, and the one that makes the present value of the free cash

inflows equal to the initial outlay, that is makes the NPV equal to zero, is the IRR.

15% $22,588.

20% -$31,504.

17% $0

9-12. Calculator Solution (using a Texas Instruments BA-II Plus):

Data and Key Input Display

CF; -927,917; ENTER CF0 = -927,917.00

↓; 200,000; ENTER C01 = 200,000.00

↓; 1; ENTER F01 = 1.00

↓; 300,000; ENTER C02 = 300,000.00

↓; 2; ENTER F02 = 2.00

↓; 200,000; ENTER C03 = 200,000.00

↓; 2; ENTER F03 = 2.00

↓; 160,000; ENTER C04 = 160,000.00

↓; 1; ENTER F04 = 1.00

IRR; CPT IRR = 13.00

Try different discount rates, and the one that makes the present value of the free cash

inflows equal to the initial outlay, that is makes the NPV equal to zero, is the IRR.

Discount Rate Guesses NPV

10% $78,332.

15% -$46,947.

13% $0

Thus, 13 percent is the project’s IRR.

287

TV inflows

9-13. (a) PVoutflows =

(1 + MIRR) n

$2,000,000(FVIFA10%,8years )

$8,000,000 =

(1 + MIRR)8

$2,000,000(11.436)

$8,000,000 =

(1 + MIRR)8

$22,872000

$8,000,000 =

(1 + MIRR)8

MIRR = 14.0320%

$2,000,000(FVIFA12%,8years )

b) $8,000,000 =

(1 + MIRR)8

$2,000,000(12.300)

$8,000,000 =

(1 + MIRR)8

$24,600,000

$8,000,000 =

(1 + MIRR)8

MIRR = 15.0749%

$2,000,000(FVIFA14%,8years )

c) $8,000,000 =

(1 + MIRR)8

$2,000,000(13.233)

$8,000,000 =

(1 + MIRR)8

$26,466,000

$8,000,000 =

(1 + MIRR)8

MIRR = 16.1312%

$700

9-14. a. NPVA = - $500

(1 + 0.10)1

= $636.30 - $500

= $136.30

$6,000

NPVB = - $5,000

(1 + 0.10)1

= $5,455 - $5,000

= $455

288

$636.30

b. PIA =

$500.00

= 1.2726

$5,455

PIB =

$5,000

= 1.0910

c. $500 = $700 [PVIFIRR%,1 yr]

0.714 = PVIFIRR%,1 yr

$5,000 = $6,000 [PVIFIRR%,1 yr]

net present value. If there is a capital constraint, the problem then focuses on what

can be done with the additional $4,500 freed up if project A is chosen. If Dorner

Farms can earn more on project A, plus the project financed with the additional

$4,500, than it can on project B, then project A and the marginal project should be

accepted.

9-15. a. Payback A = 3.2 years

Payback B = 4.5 years

B assumes even cash flow throughout year 5.

5 $15,625

b. NPVA = ∑ - $50,000

t = 1 (1 + 0.10 )

t

= $59,234 - $50,000

= $9,234

$100,000

NPVB = - $50,000

5

(1 + 0.10)

= $100,000 (0.621) - $50,000

= $62,100 - $50,000

= $12,100

289

c. $50,000 = $15,625 [PVIFAIRR %,5 yrs]

A

3.2 = PVIFAIRR%,5 yrs

Thus, IRRA = 17%

$50,000 = $100,000 [PVIFIRR %,5 yrs]

B

.50 = PVIFAIRR %,5 yrs

B

Thus, IRRB = 15%

d. The conflicting rankings are caused by the differing reinvestment assumptions

made by the NPV and IRR decision criteria. The NPV criteria assumes that cash

flows over the life of the project can be reinvested at the required rate of return or

cost of capital, while the IRR criterion implicitly assumes that the cash flows over

the life of the project can be reinvested at the internal rate of return.

e. Project B should be taken because it has the largest NPV. The NPV criterion is

preferred because it makes the most acceptable assumption for the wealth-

maximizing firm.

Profitability of Future

Project Cost Index Cash Flows NPV

A $4,000,000 1.18 $4,720,000 $ 720,000

B 3,000,000 1.08 3,240,000 240,000

C 5,000,000 1.33 6,650,000 1,650,000

D 6,000,000 1.31 7,860,000 1,860,000

E 4,000,000 1.19 4,760,000 760,000

F 6,000,000 1.20 7,200,000 1,200,000

G 4,000,000 1.18 4,720,000 720,000

A&B $ 7,000,000 $ 960,000

A&C 9,000,000 2,370,000

A&D 10,000,000 2,580,000

A&E 8,000,000 1,480,000

A&F 10,000,000 1,920,000

A&G 8,000,000 1,440,000

B&C 8,000,000 1,890,000

B&D 9,000,000 2,100,000

B&E 7,000,000 1,000,000

B&F 9,000,000 1,440,000

B&G 7,000,000 960,000

C&D 11,000,000 3,510,000

290

C&E 9,000,000 2,410,000

C&F 11,000,000 2,850,000

C&G 9,000,000 2,370,000

D&E 10,000,000 2,620,000

D&F 12,000,000 3,060,000

D&G 10,000,000 2,580,000

E&F 10,000,000 1,960,000

E&G 8,000,000 1,480,000

F&G 10,000,000 1,920,000

A&B&C 12,000,000 2,610,000

A&B&E 11,000,000 1,720,000

A&B&G 11,000,000 1,680,000

A&E&G 12,000,000 2,200,000

B&C&E 12,000,000 2,650,000

B&C&G 12,000,000 2,610,000

Thus, projects C&D should be selected under strict capital rationing as they

provide the combination of projects with the highest net present value.

b. Because capital rationing forces the rejection of profitable projects, it is not an

optimal strategy.

a. Capital-budgeting decisions involve investments requiring rather large cash outlays at the

beginning of the life of the project and commit the firm to a particular course of action

over a relatively long time horizon. As such, they are both costly and difficult to reverse,

both because of: (1) their large cost and (2) the fact that they involve fixed assets, which

cannot be liquidated easily.

b. Axiom 5: “The Curse of Competitive Markets—Why It’s Hard to Find Exceptionally

Profitable Projects” deals with the problems associated with finding profitable projects.

When we introduced that axiom, we stated that exceptionally successful investments

involve the reduction of competition by creating barriers to entry either through product

differentiation or cost advantages. In effect, without barriers to entry, whenever

extremely profitable projects are found, competition rushes in, driving prices and profits

down unless there is some barrier to entry.

20,000

c. Payback periodA = 3 years + years = 3.4years

50,000

110,000

Payback PeriodB = years = 2.75 years

40,000

Project B should be accepted, while project A should be rejected.

d. The disadvantages of the payback period are: (1) ignores the time value of money, (2)

ignores cash flows occurring after the payback period, (3) selection of the maximum

acceptable payback period is arbitrary.

291

n

FCFt

e. NPVA = ∑ (1 + k )

t =1

t

- IO

+ $40,000(PVIF12%, 3 years) + $50,000 (PVIF12%, 4 years)

+ $70,000(PVIF12, 5 years) - $110,000

= $20,000(.893) + $30,000 (.797) + $40,000 (.712) + $50,000 (.636)

+ $70,000 (.567) - $110,000

= $17,860 + $23,910 + $28,480 + $31,800 + $39,690 - $110,000

= $141,740-$110,000

= $31,740

NPVB = $40,000(PVIFA12%, 5 years) - $110,000

= $40,000(3.605) - $110,000

= $144,200-$110,000

= $34,200

Both projects should be accepted

f. The net present value technique discounts all the benefits and costs in terms of cash flows

back to the present and determines the difference. If the present value of the benefits

outweighs the present value of the costs, the project is accepted; if not, it is rejected.

n

∑ FCFt

t =1

(1 + k )t

g. PIA =

IO

$141,740

=

$110,000

= 1.2885

$144,200

PIB =

$110,000

= 1.3109

Both projects should be accepted

292

h. The net present value and the profitability index always give the same accept reject-

decision. When the present value of the benefits outweighs the present value of the costs,

the profitability index is greater than one, and the net present value is positive. In that

case, the project should be accepted. If the present value of the benefits is less than the

present value of the costs, then the profitability index will be less than one; thus, the net

present value will be negative, and the project will be rejected.

i. For both projects A and B, all of the costs are already in present dollars and, as such, will

not be affected by any change in the required rate of return or discount rate. All the

benefits for these projects are in the future, and thus when there is a change in the

required rate of return or discount rate, their present value will change. If the required

rate of return increased, the present value of the benefits would decline which would in

turn result in a decrease in both the net present value and the profitability index for each

project.

j. IRRA = 20.9698%

IRRB = 23.9193%

k. The required rate of return does not change the internal rate of return for a project, but it

does affect whether a project is accepted or rejected. The required rate of return is the

hurdle rate that the project’s IRR must exceed in order to accept the project.

l. The net present value assumes that all cash flows over the life of the project are

reinvested at the required rate of return, while the internal rate of return implicitly

assumes that all cash flows over the life of the project are reinvested over the remainder

of the project’s life at the IRR. The net present value method makes the most acceptable

and conservative assumption and, thus, is preferred.

$240,000

m. 1. NPVA = - $195,000

(1 + 0.10)1

= $218,182 - $195,000

= $23,182

$1,650,000

NPVB = - $1,200,000

1

(1 + 0.10)

= $1,500,000 - $1,200,000

= $300,000

$218,182

2. PIA =

$195,000

= 1.1188

$1,499,850

PIB =

$1,200,000

= 1.25

293

3. $195,000 = $240,000 [PVIFIRR %,1 yr]

A

0.8125 = PVIFIRR %,1 yr

A

Thus, IRRA = 23%

$1,200,000 = $1,650,000 [PVIFIRR %,1 yr]

B

0.7273 = [PVIFIRR %,1 yr]

B

Thus, IRRB = 38%

4. If there is no capital rationing, project B should be accepted because it has a larger

net present value. If there is a capital constraint, the problem then focuses on

what can be done with the additional $1,005,000 freed up if project A is chosen.

If Caledonia can earn more on project A, plus the project financed with the

additional $1,005,000, than it can on project B, then project A and the marginal

project should be accepted.

n. Two answers are provided, one assuming an initial outlay of $100,000 (the initial outlay

that should have appeared in the text) and one an initial outlay of $10,000 (the value of

the initial outlay that did appear in the book).

If the initial outlay for project A was $100,000, the answers for project A would be as

follows:

1. Payback A = 3.125 years

Payback B = 4.5 years

B assumes even cash flow throughout year 5.

5 $32,000

2. NPVA = ∑ - $100,000

t = 1 (1 + 0.11)

t

= $118,272 - $100,000

= $18,272

$200,000

NPVB = - $100,000

(1 + 0.11) 5

= $200,000 (0.593) - $100,000

= $118,600 - $100,000

= $18,600

294

3. $100,000 = $32,000 [PVIFAIRR %,5 yrs]

A

3.125 = PVIFAIRR %,5 yrs

A

Thus, IRRA = 18.03%

$100,000 = $200,000 [PVIFIRR %,5 yrs]

B

.50 = PVIFIRR %,5 yrs

B

Thus, IRRB is just under 15% (14.87%).

4. The conflicting rankings are caused by the differing reinvestment assumptions

made by the NPV and IRR decision criteria. The NPV criteria assume that cash

flows over the life of the project can be reinvested at the required rate of return or

cost of capital, while the IRR criterion implicitly assumes that the cash flows over

the life of the project can be reinvested at the internal rate of return.

5. Project B should be taken because it has the largest NPV. The NPV criterion is

preferred because it makes the most acceptable assumption for the wealth-

maximizing firm.

If the initial outlay for project A was $10,000, the answers for project A would become:

1. Payback A = 0.31 years

5 $32,000

2. NPVA = ∑ - $10,000

t =1 (1 + 0.11) t

= $32,000 (3.696) - $10,000

= $118,272 - $10,000

= $18,272

$200,000

NPVB = - $10,000

5

(1 + 0.11)

= $200,000 (0.593) - $10,000

= $118,600 - $10,000

= $108,600

3. IRR = 319.75%

4. In this case there is no ranking conflict.

5. Accept project A.

295

o. 1. Payback A = 1.5385 years

Payback B = 3.0769 years

3 $65,000

2. NPVA = ∑ - $100,000

t =1 (1 + 0.14 ) t

= $65,000 (2.322) - $100,000

= $150,930 - $100,000

= $50,930

9 $32,500

NPVB = ∑ - $100,000

t =1 (1 + 0.14 ) t

= $32,500 (4.946) - $100,000

= $160,745 - $100,000

= $60,745

3. $100,000 = $65,000 [PVIFAIRR %,3 yrs]

A

Thus, IRRA = over 40% (42.57%)

$100,000 = $32,500 [PVIFAIRR %,9 yrs]

B

Thus, IRRB = 29%

4. These projects are not comparable because future profitable investment proposals

are affected by the decision currently being made. If project A is taken, at its

termination the firm could replace the machine and receive additional benefits,

while acceptance of project B would exclude this possibility.

Year Cash flow

0 -$100,000

1 65,000

2 65,000

3 -35,000

4 65,000

5 65,000

6 - 35,000

7 65,000

8 65,000

9 65,000

296

9 $65,000 $100,000 $100,000

NPVA = ∑ - $100,000 - -

t = 1 (1 + 0.14 )

t

(1 + 0.14) 3 (1 + 0.14) 6

= $65,000(4.946) - $100,000 - $100,000 (0.675)

- $100,000 (0.456)

= $321,490 - $100,000 - $67,500 - $45,600

= $108,390

The replacement chain analysis indicated that project A should be selected, since the

replacement chain associated with it has a larger NPV than project B.

Project A’s EAA:

Step 1: Calculate the project’s NPV (from part b):

NPVA = $50,930

Step 2: Calculate the EAA:

EAAA = NPV / PVIFA14%, 3 yr.

= $50,930/ 2.322

= $21,934

Project B’s EAA:

Step 1: Calculate the project’s NPV (from part b):

NPVB = $60,745

Step 2: Calculate the EAA:

EAAB = NPV / PVIFA14%, 9 yr.

= $60,745 / 4.946

= $12,282

Project A should be selected because it has a higher EAA.

297

FORD PINTO

There was a time when the “made in Japan” label brought a predictable smirk of superiority to

the face of most Americans. The quality of most Japanese products usually was as low as their

price. In fact, few imports could match their domestic counterparts, the proud products of

"Yankee know-how." But by the late 1960s, an invasion of foreign-made goods chiseled a few

worry lines into the countenance of American industry. And in Detroit, worry was fast fading to

panic as the Japanese, not to mention the Germans, began to gobble up more and more of the

subcompact auto market.

Never one to take a back seat to the competition, Ford Motor Company decided to meet the

threat from abroad head-on. In 1968, Ford executives decided to produce the Pinto. Known

inside the company as "Lee’s car," after Ford president Lee Iacocca, the Pinto was to weigh no

more than 2,000 pounds and cost no more than $2,000.

Eager to have its subcompact ready for the 1971 model year, Ford decided to compress the

normal drafting-board-to-showroom time of about three-and-a-half years into two. The

compressed schedule meant that any design changes typically made before production-line

tooling would have to be made during it.

Before producing the Pinto, Ford crash-tested eleven of them, in part to learn if they met the

National Highway Traffic Safety Administration (NHTSA) proposed safety standard that all

autos be able to withstand a fixed-barrier impact of 20 miles per hour without fuel loss. Eight

standard-design Pintos failed the tests. The three cars that passed the test all had some kind of

gas-tank modification. One had a plastic baffle between the front of the tank and the differential

housing; the second had a piece of steel between the tank and the rear bumper; and the third had

a rubber-lined gas tank.

Ford officials faced a tough decision. Should they go ahead with the standard design, thereby

meeting the production timetable but possibly jeopardizing consumer safety? Or should they

delay production of the Pinto by redesigning the gas tank to make it safer and thus concede

another year of subcompact dominance to foreign companies?

To determine whether to proceed with the original design of the Pinto fuel tank, Ford decided to

use a capital-budgeting approach, examining the expected costs and the social benefits of making

the change. Would the social benefits of a new tank design outweigh design costs, or would they

not?

To find the answer, Ford had to assign specific values to the variables involved. For some factors

in the equation, this posed no problem. The costs of design improvement, for example, could be

estimated at eleven dollars per vehicle. But what about human life? Could a dollar-and-cents

figure be assigned to a human being?

NHTSA thought it could. It had estimated that society loses $200,725 every time a person is

killed in an auto accident. It broke down the costs as follows:

298

Future productivity losses

Direct $132,000

Indirect 41,300

Medical costs

Hospital 700

Other 425

Property damage 1,500

Insurance administration 4,700

Legal and court expenses 3,000

Employer losses 1,000

Victim’s pain and suffering 10,000

Funeral 900

Assets (lost consumption) 5,000

Miscellaneous accident costs 200

1

Total per fatality $200,725

Ford used NHTSA and other statistical studies in its cost-benefit analysis, which yielded the

following estimates:

Benefits

Savings: 180 burn deaths; 180 serious burn injuries;

2,100 burned vehicles

Unit cost: $200,000 per death; $67,000 per injury;

$700 per vehicle

Total benefit: (180 x $200,000) + (180 x $67,000)

+ (2,100 x $700) = $49.5 million

Costs

Sales: 11 million cars, 1.5 million light trucks

Unit cost: $11 per car, $11 per truck

2

Total cost: 12.5 million x $11 = $137.5 million

Since the costs of the safety improvement outweighed its benefits, Ford decided to push ahead

with the original design.

Here is what happened after Ford made this decision:

1

Ralph Drayton, "One Manufacturer's Approach to Automobile Safety Standards," CTLA News 8 (February 1968),

p. 11.

2

Mark Dowie, "Pinto Madness,'' Mother Jones, September–October 1977, p. 20. See also Russell Mokhiber,

Corporate Crime and Violence (San Francisco: Sierra Club Books, 1988), pp. 373-382; and Francis T. Cullen,

William J. Maakestad, and Gary Cavender, Corporate Crime Under Attack: The Ford Pinto Case and Beyond

(Cincinnati: Anderson Publishing, 1987).

299

Between 700 and 2,500 persons died in accidents involving Pinto fires between 1971 and 1978.

According to sworn testimony of Ford engineer Harley Copp, 95% of them would have survived

if Ford had positioned the fuel tank over the axle (as it had done on its Capri automobiles).

NHTSA’s standard was adopted in 1977. The Pinto then acquired a rupture-proof fuel tank. The

following year Ford was obliged to recall all 1971-1976 Pintos for fuel-tank modifications.

Between 1971 and 1978, approximately fifty lawsuits were brought against Ford in connection

with rear-end accidents involving the Pinto. In the Richard Grimshaw case, in addition to

awarding over $3 million in compensatory damages to the victims of a Pinto crash, the jury

awarded a landmark $125 million in punitive damages against Ford. The judge reduced punitive

damages to $3.5 million.

On August 10, 1978, 18-year-old Judy Ulrich, her 16-year-old sister Lynn, and their 18-year-old

cousin Donna, in their 1973 Ford Pinto, were struck from the rear by a van near Elkhart, Indiana.

The gas tank of the Pinto exploded on impact. In the fire that resulted, the three teenagers were

burned to death. Ford was charged with criminal homicide. The judge presiding over the 20-

week trial advised jurors that Ford should be convicted if it had clearly disregarded the harm that

might result from its actions, and that disregard represented a substantial deviation from

acceptable standards of conduct. On March 13, 1980, the jury found Ford not guilty of criminal

homicide.

For its part, Ford has always denied that the Pinto is unsafe compared with other cars of its type

and era. The company also points out that in every model year the Pinto met or surpassed the

government’s own standards. But what the company does not say is that successful lobbying by

it and its industry associates was responsible for delaying for 9 years the adoption of NHTSA’s

20-miles-per-hour crash standard. And Ford’s critics claim that there were more than forty

European and Japanese models in the Pinto price and weight range with safer gas-tank position.

"Ford made an extremely irresponsible decision," concludes auto safety expert Byron Bloch,

"when they placed such a weak tank in such a ridiculous location in such a soft rear end."

QUESTIONS

1. Do you think Ford approached this question properly?

2. What responsibilities to its customers do you think Ford had? Were their actions ethically

appropriate?

3. Would it have made a moral or ethical difference if the $11 savings had been passed on

to Ford’s customers? Could a rational customer have chosen to save $11 and risk the

more dangerous gas tank? Would that have been similar to making air bags optional?

What if Ford had told potential customers about its decision?

4. Should Ford have been found guilty of criminal homicide in the Ulrich case?

5. If you, as a financial manager at Ford, found out about what had been done, what would

you do?

Adapted by permission from William Shaw and Vincent Barry, Moral Issues in Business, 7th

ed., pp. 84–87. Copyright 1992 by Wadsworth, Inc.

300

FORD PINTO

(Ethics in Capital Budgeting)

OBJECTIVE: To force the students to recognize the role ethical behavior plays in all

areas of Finance.

Case Solution:

With ethics cases, there are no right or wrong answers—just opinions. Try to bring out as

many opinions as possible without being judgmental.

301

HARDING PLASTIC MOLDING COMPANY

On January 11, 1993, the finance committee of Harding Plastic Molding Company (HPMC) met

to consider 8 capital-budgeting projects. Present at the meeting were Robert L. Harding,

president and founder, Susan Jorgensen, comptroller, and Chris Woelk, head of research and

development. Over the past 5 years, this committee met every month to consider and make final

judgment on all proposed capital outlays brought up for review during the period.

Harding Plastic Molding Company was founded in 1965 by Robert L. Harding to produce plastic

parts and molding for the Detroit automakers. For the first 10 years of operations, HPMC worked

solely as a subcontractor for the automakers, but since then has made strong efforts to diversify

in an attempt to avoid the cyclical problems faced by the auto industry. By 1993, this

diversification attempt led HPMC into the production of over 1,000 different items, including

kitchen utensils, camera housings, and phonographic and recording equipment. It also led to an

increase in sales of 800% during the 1975–1993 period. As this dramatic increase in sales was

paralleled by a corresponding increase in production volume, HPMC was forced, in late 1991, to

expand production facilities. This plant and equipment expansion involved capital expenditures

of approximately $10.5 million and resulted in an increase of production capacity of about 40%.

Because of this increased production capacity, HPMC made a concerted effort to attract new

business and consequently recently entered into contracts with a large toy firm and a major

discount department store chain. While non-auto-related business has grown significantly, it still

represents only 32% of HPMC’s overall business. Thus, HPMC has continued to solicit non-

automotive business, and, as a result of this effort and its internal research and development, the

firm has four sets of mutually exclusive projects to consider at this month’s finance committee

meeting.

Over the past 10 years, HPMC’s capital-budgeting approach evolved into a somewhat elaborate

procedure in which new proposals are categorized into three areas: profit, research and

development, and safety. Projects falling into the profit or research and development areas are

evaluated using present value techniques, assuming a 10 percent opportunity rate; those falling

into the safety classification are evaluated in a more subjective framework. Although research

and development projects have to receive favorable results from the present value criteria, there

is also a total dollar limit assigned to projects of this category, typically running about $750,000

per year. This limitation was imposed by Harding primarily because of the limited availability of

quality researchers in the plastics industry. Harding felt that if more funds than this were

allocated, “we simply couldn’t find the manpower to administer them properly.” The benefits

derived from safety projects, on the other hand, are not in terms of cash flows; hence, present

value methods are not used at all in their evaluation. The subjective approach used to evaluate

safety projects is a result of the pragmatically difficult task of quantifying the benefits from these

projects in dollar terms. Thus, these projects are subjectively evaluated by a management-worker

committee with a limited budget. All 8 projects to be evaluated in January are classified as profit

projects.

302

The first set of projects listed on the meeting’s agenda for examination involve the utilization of

HPMC’s precision equipment. Project A calls for the production of vacuum containers for

thermos bottles produced for a large discount hardware chain. The containers would be

manufactured in 5 different size and color combinations. This project would be carried out over a

3-year period, for which HPMC would be guaranteed a minimum return plus a percentage of the

sales. Project B involves the manufacture of inexpensive photographic equipment for a national

photography outlet. Although HPMC currently has excess plant capacity, each of these projects

would utilize precision equipment of which the excess capacity is limited. Thus, adopting either

project would tie up all precision facilities. In addition, the purchase of new equipment would be

both prohibitively expensive and involve a time delay of approximately 2 years, thus making

these projects mutually exclusive. (The cash flows associated with these 2 projects are given in

Exhibit 1.)

The second set of projects involves the renting of computer facilities over a 1-year period to aid

in customer billing and, perhaps, inventory control. Project C entails the evaluation of a customer

billing system proposed by Advanced Computer Corporation. Under this system, all the

bookkeeping and billing presently being done by HPMC’s accounting department would be done

by Advanced. In addition to saving costs involved in bookkeeping, Advanced would provide a

more efficient billing system and do a credit analysis of delinquent customers, which could be

used in the future for in-depth credit analysis. Project D is proposed by International Computer

Corporation and includes a billing system similar to that offered by Advanced. In addition, an

inventory control system that will keep track of all raw materials and parts in stock and reorder

when necessary. Thereby, reducing the likelihood of material stockouts, which have become

more and more frequent over the past 3 years. (The cash flows for these projects are given in

Exhibit 2.)

EXHIBIT 1.

Harding Plastic Molding Company

Cash Flows:

Year Project A Project B

0 $-75,000 $-75,000

1 10,000 43,000

2 30,000 43,000

3 100,000 43,000

EXHIBIT 2.

Harding Plastic Molding Company

Cash Flows:

Year Project C Project D

0 $-8,000 $-20,000

1 11,000 25,000

The third decision that faces the financial directors of HPMC involves a newly developed and

patented process for molding hard plastics. HPMC can either manufacture and market the

equipment necessary to mold such plastics or it can sell the patent rights to Polyplastics

Incorporated, the world’s largest producer of plastics products. (The cash flows for projects E

303

and F are shown in Exhibit 3.) At present, the process has not been fully tested, and if HPMC is

going to market it itself, it will be necessary to complete this testing and begin production of

plant facilities immediately. On the other hand, the selling of these patent rights to Polyplastics

would involve only minor testing and refinements, which could be completed within the year.

Thus, a decision as to the proper course of action is necessary immediately.

The final set of projects up for consideration revolve around the replacement of some of the

machinery. HPMC can go in one of two directions. Project G suggests the purchase and

installation of moderately priced, extremely efficient equipment with an expected life of 5 years;

project H advocates the purchase of a similarly priced, although less efficient, machine with a

life expectancy of 10 years. (The cash flows for these alternatives are shown in Exhibit 4.)

As the meeting opened, debate immediately centered on the most appropriate method for

evaluating all the projects. Harding suggested that, as the projects to be considered were

mutually exclusive, perhaps their usual capital-budgeting criteria of net present value was

inappropriate. He felt that, in examining these projects, perhaps they should be more concerned

with relative profitability or some measure of yield. Both Jorgensen and Woelk agreed with

Harding’s point of view, with Jorgensen advocating a profitability index approach and Woelk

preferring the use of the internal rate of return. Jorgensen argued that the use of the profitability

index would provide a benefit-cost ratio, directly implying relative profitability. Thus, they

merely need to rank these projects and select those with the highest profitability index. Woelk

agreed with Jorgensen’s point of view but suggested that the calculation of an internal rate of

return would also give a measure of profitability and perhaps be somewhat easier to interpret. To

settle the issue, Harding suggested they calculate all three measures, as they would undoubtedly

yield the same ranking.

EXHIBIT 3.

Harding Plastic Molding Company

Cash Flows:

Year Project E Project F

0 $-30,000 $-271,500

1 210,000 100,000

2 100,000

3 100,000

4 100,000

5 100,000

6 100,000

7 100,000

8 100,000

9 100,000

10 100,000

304

EXHIBIT 4.

Harding Plastic Molding Company

Cash Flows:

Year Project G Project H

0 $-500,000 $-500,000

1 225,000 150,000

2 225,000 150,000

3 225,000 150,000

4 225,000 150,000

5 225,000 150,000

6 150,000

7 150,000

8 150,000

9 150,000

10 150,000

From here, the discussion turned to an appropriate approach to the problem of differing lives

among mutually exclusive projects E and F, and G and H. Woelk argued that there really was not

a problem here at all that as all the cash flows from these projects can be determined, any of the

discounted cash flow methods of capital budgeting will work well. Jorgensen argued that,

although this was true, some compensation should be made for the fact that the projects being

considered did not have equal lives.

QUESTIONS

1. Was Harding correct in stating that the NPV, PI, and IRR necessarily will yield

the same ranking order? Under what situations might the NPV, PI, and IRR

methods provide different rankings? Why is it possible?

2. What are the NPV, PI, and IRR for projects A and B? What has caused the

ranking conflicts? Should project A or B be chosen? Might your answer change if

project B is a typical project in the plastic molding industry? For example, if

projects for HPMC generally yield approximately 12%, is it logical to assume that

the IRR for project B of approximately 33% is a correct calculation for ranking

purposes?

3. What are the NPV, PI, and IRR for projects C and D? Should project C or D be

chosen? Does your answer change if these projects are considered under a capital

constraint? What return on the marginal $12,000 not employed in project C is

necessary to make one indifferent to choosing one project over the other under a

capital-rationing situation?

4. What are the NPV, PI, and IRR for projects E and F? Are these projects

comparable even though they have unequal lives? Why? Which project should be

chosen? Assume that these projects are not considered under a capital constraint.

5. What are the NPV, PI, and IRR for projects G and H? Are these projects

comparable even though they have unequal lives? Why? Which project should be

chosen? Assume that these projects are not considered under a capital constraint.

305

HARDING PLASTIC MOLDING COMPANY

(Capital Budgeting: Ranking Problems)

OBJECTIVE: The objective of this case is to explore the ranking differences that may

result from using the PI, NPV, and IRR evaluation techniques. It

illustrates the time disparity, size disparity, and life disparity problems and

the appropriate approaches to the resolution of these problems. This case

works well either as a homework problem coinciding with the introduction

of project ranking and capital-rationing material or as an in-class problem

lecture.

Question Answers

1. No. While, in general, it is true that when one discounted cash flow method (NPV, PI, or

IRR) gives a project an acceptable rating, the other two methods also give this project an

acceptable rating; it is not necessarily true that these discounted cash flow methods will

rank these acceptable projects in the same order. Ranking differences may occur as a

result of (a) the time disparity problem resulting from differences in the cash inflow

patterns over time between two projects; (b) the size disparity problem, resulting from the

comparison of projects requiring initial cash outflows of differing size; or (c) the life

disparity problem, resulting from projects with differing lives. These problems are

illustrated in the case with Projects A and B representing the time disparity problem, C

and D, the size disparity problem, and with E, F, G, and H, the life disparity problem.

The ranking problems incurred using the discounted cash flow methods are generally a

function of the different assumptions made about the reinvestment opportunities for cash

inflows over the life of the project.

2. Project A Project B

NPV = $34,015.40 NPV = $31,932.40

PI = 1.4535 PI = 1.4258

IRR = 27.1949% IRR = 32.9189%

In this case, the ranking conflicts have come as a result of the different assumptions made

as to the reinvestment opportunities available for cash inflows over the life of the project.

The NPV and PI methods assume that these cash inflows can be reinvested at the cost of

capital, while the IRR method assumes they can be reinvested at the IRR rate. Thus, the

correct investment decision as to acceptance of Project A or B becomes a function of

which assumption is more accurate. When the reinvestment rate is unknown, the more

conservative approach is to use the net present value criterion as it uses the required rate

of return as its reinvestment rate. Since no project will be accepted returning less than

this value, this must be at least a minimum reinvestment rate, and, for this reason, is

preferred. Here Project A should be selected as it has a

306

higher NPV. If, however, Project B is a typical project, then its IRR of 33% becomes a

good approximation for the reinvestment rate for ranking purposes, and Project B should

then be selected as the IRR assumption now appears more valid. Finally, if it is true that

HPMC’s projects typically yield approximately 12%, then the 33% IRR of Project B is

somewhat overstated for ranking purposes.

3. Project C Project D

NPV = $2,000.00 NPV = $2,727.25

PI = 1.25 PI = 1.136

IRR = 37.5% IRR = 25.0%

In the absence of capital rationing, Project D should be selected as it has the largest net

present value, representing the largest increase to shareholders’ wealth. The net present

value of a project is the net increase in value to the firm provided this project is accepted.

Thus, when there is no explicit limitation on the size of the firm’s capital budget, (i.e., in

the absence of capital rationing) the net present value criterion should be used to solve

the size disparity problem. However, in the case of capital rationing, the decision-making

process is more difficult and becomes a function of the investment opportunities available

for the funds freed up by the acceptance of the smaller project (in this case, the

investment opportunities available on the marginal $12,000). In effect, when a capital-

rationing constraint is imposed upon this problem, the acceptance of Project C provides

the firm with $12,000 more to invest on other projects than would have been available if

the firm had chosen Project D. If the firm can invest this $12,000 in marginal projects

(that is, projects that would have been rejected had the firm accepted Project D) and earn

a return of more than $14,000 on this investment, Project C should be chosen; if it cannot

earn a return of $14,000, Project D should be selected. In effect, the firm should be

indifferent between the selection of Project C (initial outlay of $8,000, cash inflow in

year 1 of $11,000) in conjunction with a marginal project with an initial outlay of

$12,000 and a cash inflow in year 1 of $14,000 and Project D (initial outlay of $20,000

and cash inflow of $25,000 in year 1). In other words, if the firm can earn more than

16.667% on the marginal $12,000, Project C should be selected.

IRR = 16.667%

307

4. Project E Project F

NPV = 160,908.90 NPV = 342,960.00

PI = 6.3636 PI = 2.2632

IRR = 600.0% IRR = 35.0006%

1

(Calculation of IRR for Project E: $30,000 = $210,000

1+ i

(1+ i) = 7

(as i = 6.0 or 600%)

The problem of incomparability of projects with different lives is not directly a result of

the projects having different lives but of the fact that future profitable investment

proposals are affected by the decision currently being made. This can easily be seen in

the replacement problem where two machine replacements with different lives are being

considered. In this case, a comparison of the net present values alone on each of these

projects would be misleading because, if the project with the shorter life is taken, at its

end it would be possible to replace this machine and receive additional benefits, while

acceptance of the project with the longer life would prohibit this possibility. This

situation is portrayed in the next example dealing with Projects G and H.

In the case at hand, the decision to accept one project as opposed to the other does not

affect the ability to accept or reject future projects. Thus, although these projects have

unequal lives, they are comparable. Acceptance of the project with the longer life does

not eliminate any other projects from consideration as is the case in the replacement

problem; thus, while these projects have different lives, they are comparable. As Project

F has the largest net present value, it should be taken.

5. Project G Project H

NPV = $352,930.00 NPV = $421,690.00

PI = 1.7059 PI = 1.8434

IRR = 034.9433% IRR = 27.3198%

In this case, the projects are not comparable because acceptance of the project with the

shorter life provides the firm with the opportunity to replace this machine after five years

and reap additional benefits, while acceptance of the project with the longer life prohibits

this opportunity. In effect, the investment decision made today affects future profitable

investment proposals; thus, the projects are not comparable. There are several methods

to deal with this situation. The first method is to assume that cash inflows will be

reinvested at the discount rate (cost of capital). While this approach is the simplest,

merely calculating the net present value, it actually avoids the problem at hand, that of

allowing for participation in another replacement opportunity with a positive net present

value. The proper solution thus becomes the projection of reinvestment opportunities

into the future, that is, making assumptions as to possible investment opportunities

available in the future. Unfortunately, while the first method is too simplistic to be of any

value, the second method is pragmatically difficult, requiring extensive forecasts. The

final method of dealing with the problem is to assume that reinvestment opportunities in

the future will be similar to the current ones. The most common way of doing this is the

308

creation of a replacement chain to equalize life spans. In this case, it would call for the

creation of a 2-chain cycle for Project G, assuming Project G can be replaced with a

project similar to itself at the end of 5 years. Alternatively, this can be solved through the

creation of annual equivalents (i.e., the annuity value over the life of the project that is

equivalent to the project’s NPV. In the case of Project G, it is the 5-year annuity given

the discount rate of 10% that has a NPV of $352,930.00 As these two approaches make

identical assumptions, they will provide identical results. These values for Projects G

and H are as follows:

Project G Project H

Year Cash Flow PV Year Cash Flow PV

0 -$500,000 -$500,000 0 -$500,000 -$500,000

1-5 225,000 852,930 1-10 150,000 921,690

5 - 500,000 - 310,460 NPV $421,690

6-10 225,000 529,605

NPV $572,075

Annual Equivalents

Project G Project H

NPV = $352,930.00 NPV = $421,690.00

Present Value factor 10% Present Value factor 10%

for 5 years = 3.7908 for 10 years = 6.1446

Annual Equivalent = X Annual Equivalent = X

X = $93,101.72 X = $68,627.74

309

ALTERNATIVE PROBLEMS AND SOLUTIONS

ALTERNATIVE PROBLEMS

9-1A. (IRR Calculation) Determine the internal rate of return on the following projects:

a. An initial outlay of $10,000 resulting in a single cash flow of $19,926 after 8 years

b. An initial outlay of $10,000 resulting in a single cash flow of $20,122 after 12

years

c. An initial outlay of $10,000 resulting in a single cash flow of $121,000 after 22

years

d. An initial outlay of $10,000 resulting in a single cash flow of $19,254 after 5 years

9-2A. (IRR Calculation) Determine the internal rate of return on the following projects:

a. An initial outlay of $10,000 resulting in a cash flow of $2,146 at the end of each

year for the next 10 years

b. An initial outlay of $10,000 resulting in a cash flow of $1,960 at the end of each

year for the next 20 years

c. An initial outlay of $10,000 resulting in a cash flow of $1,396 at the end of each

year for the next 12 years

d. An initial outlay of $10,000 resulting in a cash flow of $3,197 at the end of each

year for the next 5 years

9-3A. (IRR Calculation) Determine the internal rate of return to the nearest percent on the

following projects:

a. An initial outlay of $10,000 resulting in a cash flow of $3,000 at the end of year 1,

$5,000 at the end of year 2, and $7,500 at the end of year 3.

b. An initial outlay of $12,000 resulting in a cash flow of $9,000 at the end of year 1,

$6,000 at the end of year 2, and $2,000 at the end of year 3.

c. An initial outlay of $8,000 resulting in a cash flow of $2,000 at the end of years 1

through 5, and $5,000 at the end of year 6.

9-4A. (NPV, PI, and IRR Calculations) Gecewich, Inc. is considering a major expansion of its

product line and has estimated the following cash flows associated with such an

expansion. The initial outlay associated with the expansion would be $2,500,000, and the

project would generate incremental after-tax cash flows of $750,000 per year for 6 years.

The appropriate required rate of return is 11%.

a. Calculate the net present value.

b. Calculate the profitability index.

c. Calculate the internal rate of return.

d. Should this project be accepted?

9-5A. No alternative problem available.

310

9-6A. No alternative problem available.

9-7A. No alternative problem available.

9-8A. No alternative problem available.

9-9A. (Internal Rate of Return Calculation) Given the following cash flows, determine the

internal rate of return for projects A, B, and C.

Initial Investment: $75,000 $95,000 $395,000

Cash Inflows:

Year 1 $10,000 25,000 150,000

Year 2 10,000 25,000 150,000

Year 3 30,000 25,000 150,000

Year 4 25,000 25,000 —

Year 5 30,000 25,000

9-10A. (NPV with Varying Required Rates of Return) Bert’s, makers of gourmet corn dogs, is

considering the purchase of a new plastic stamping machine. This investment requires an

initial outlay of $150,000 and will generate after-tax cash inflows of $25,000 per year for

10 years. For each of the listed required rates of return, determine the project’s net

present value.

a. The required rate of return is 9%.

b. The required rate of return is 15%.

c. Would the project be accepted under part a or b?

d. What is the project’s internal rate of return?

9-11A. (Size Disparity Ranking Problem) The Unk’s Farms Corporaton is considering

purchasing one of two fertilizer-herbicides for the upcoming year. The more expensive of

the two is the better and will produce a higher yield. Assume these projects are mutually

exclusive and that the required rate of return is 10%. Given the following after-tax net

cash flows:

0 –$650 –$4,000

1 800 5,500

a. Calculate the net present value.

b. Calculate the profitability index.

c. Calculate the internal rate of return.

d. If there is no capital-rationing constraint, which project should be selected? If there

is a capital-rationing constraint, how should the decision be made?

311

9-12A. (Time Disparity Ranking Problem) The Z. Bello Corporation is considering two mutually

exclusive projects. The cash flows associated with those projects are as follows:

Year Project A Project B

0 –$50,000 –$50,000

1 16,000 0

2 16,000 0

3 16,000 0

4 16,000 0

5 16,000 $100,000

a. What is each project’s payback period?

b. What is each project’s net present value?

c. What is each project’s internal rate of return?

d. What has caused the ranking conflict?

e. Which project should be accepted? Why?

9-13A. (Unequal Lives Ranking Problem) The Battling Bishops Corporation is considering two

mutually exclusive pieces of machinery that perform the same task. The two alternatives

available provide the following set of after-tax net cash flows:

0 –$20,000 –$20,000

1 13,000 6,500

2 13,000 6,500

3 13,000 6,500

4 6,500

5 6,500

6 6,500

7 6,500

8 6,500

9 6,500

Equipment A has an expected life of 3 years, whereas equipment B has an expected life

of 9 years. Assume a required rate of return of 14%.

a. Calculate each project’s payback period.

b. Calculate each project’s net present value.

c. Calculate each project’s internal rate of return.

d. Are these projects comparable?

e. Compare these projects using replacement chains and EAAs. Which project should

be selected? Support your recommendation.

312

9-14A. (EAAs) The Anduski Corporation is considering two mutually exclusive projects, one

with a 5-year life and one with a 7-year life. The after-tax cash flows from the two

projects are as follows:

0 –$40,000 –40,000

1 20,000 25,000

2 20,000 25,000

3 20,000 25,000

4 20,000 25,000

5 20,000 25,000

6 20,000

7 20,000

a. Assuming a 10% required rate of return on both projects, calculate each project’s

EAA. Which project should be selected?

b. Calculate the present value of an infinite-life replacement chain for each project.

9-15A. (Capital Rationing) The Taco Toast Company is considering seven capital investment

proposals, for which the funds available are limited to a maximum of $12 million. The

projects are independent and have the following costs and profitability indexes

associated with them:

Profitability

Project Cost Index

A $4,000,000 1.18

B 3,000,000 1.08

C 5,000,000 1.33

D 6,000,000 1.31

E 4,000,000 1.19

F 6,000,000 1.20

G 4,000,000 1.18

a. Under strict capital rationing, which projects should be selected?

b. What problems are associated with imposing capital rationing?

313

SOLUTIONS TO ALTERNATIVE PROBLEMS

9-1A. a. IO = FCFt [PVIFIRR%,t yrs]

Thus, IRR = 9%

b. $10,000 = $20,122 [PVIFIRR%,12 yrs]

Thus, IRR = 6%

c. $10,000 = $121,000 [PVIFIRR%,22 yrs]

d. $10,000 = $19,254 [PVIFIRR%,5 yrs]

9-2A. a. IO = ACFt [PVIFAIRR%,t yrs]

b. $10,000 = $1,960 [PVIFAIRR%,20 yrs]

c. $10,000 = $1,396 [PVIFAIRR%,12 yrs]

Thus, IRR = 9%

d. $10,000 = $3,197 [PVIFAIRR%,5 yrs]

Thus, IRR = 18%

314

$3,000 $5,000 $7,500

9-3A. a. $10,000 = + +

(1 + IRR )1 (1 + IRR) 2 (1 + IRR ) 3

Try 21%:

$10,000 = $3,000(0.826) + $5,000 (0.683) + $7,500 (0.564)

= $2,478+ $3,415 + $4,230

= $10,123

Try 22%

$10,000 = $3,000 (0.820) + $5,000 (0.672) + $7,500 (0.551)

= $2,460 + $3,360 + $4,132.50

= $9,952.50

Thus, IRR = approximately 22%

$9,000 $6,000 $2,000

b. $12,000 = + +

(1 + IRR )1 (1 + IRR ) 2 (1 + IRR) 3

Try 25%

$12,000 = $9,000 (0.800) + $6,000 (0.640) + $2,000 (0.512)

= $7,200 + $3,840 + $1,024

= $12,064

Try 26%:

$12,000 = $9,000 (0.794) + $6,000 (0.630) + $2,000 (0.500)

= $7,146 + $3,780 + $1,000

= $11,926

Thus, IRR = approximately 25% - 26%

5 $2,000 $5,000

c. $8,000 = ∑ +

t = 1 (1 + IRR )

t

(1 + IRR) 6

Try 18%

$8,000 = $2,000 (3.127) + $5,000 (0.370)

= $6,254 + $1,850

= $8,104

Try 19%

$8,000 = $2,000 (3.058) + $5,000 (0.352)

= $6,116 + $1,760

= $7,876

Thus, IRR = approximately 18%-19%

315

6 $750,000

9-4A. a. NPV = ∑ - $2,500,000

t = 1 (1 + .11)

t

= $3,173,250 - $2,500,000

= $673,250

$3,173,250

b. PI =

$2,500,000

= 1.2693

c. $2,500,000 = $750,000 [PVIFAIRR%,6 yrs]

d. Yes, the project should be accepted.

9-9A. Project A:

$75,000 = + +

(1 + IRR A )1 (1 + IRR A ) 2 (1 + IRR A ) 3

$25,000 $30,000

+ +

(1 + IRR A ) 4 (1 + IRR A ) 5

Try 10%

$75,000 = $10,000(.909) + $10,000(.826) + $30,000(.751)

+ $25,000(.683) + $30,000(.621)

= $9,090 + $8,260 + $22,530 + $17,075 + $18,630

= $75,585

Try 11%

$75,000 = $10,000(.901) + $10,000(.812) +$30,000(.731)

+ $25,000(.659) + $30,000(.593)

= $9,010 + $8,120 + $21,930+ $16,475 + $17,790

= $73,325

316

Thus, IRR = just over 10%

Project B:

$95,000 = $25,000 [PVIFAIRR%,5 yrs]

Project C:

$395,000 = $150,000 [PVIFAIRR%,3 yrs]

10 $25,000

9-10A. a. NPV = ∑ - $150,000

t = 1 (1 + .09 )

t

= $25,000(6.418) - $150,000

= $160,450 - $150,000

= $10,450

10 $25,000

b. NPV = ∑ - $150,000

t = 1 (1 + .15 )

t

= $25,000(5.019) - $150,000

= $125,475 - $150,000

= -$24,525

c. If the required rate of return is 9%, the project is acceptable in part a. It should be

rejected in part b with a negative NPV.

d. $150,000 = $25,000 [PVIFAIRR%,10 yrs]

$800

9-11A. a. NPVA = - $650

(1 + 0.10)1

= $727.20 - $650

= $77.20

317

$5,500

NPVB = - $4,000

(1 + 0.10)1

= $5,000 - $4,000

= $1,000

$727.20

b. PIA =

$650.00

= 1.1188

$5,000

PIB =

$4,000

= 1.25

c. $650 = $800 [PVIFIRR %,1 yr]

A

0.8125 = PVIFIRR %,1 yr

A

Thus, IRRA = 23%

$4,000 = $5,500 [PVIFIRR %,1 yr]

B

0.7273 = [PVIFIRR %,1 yr]

B

Thus, IRRB = 38%

d. If there is no capital rationing, project B should be accepted because it has a

larger net present value. If there is a capital constraint, the problem then focuses

on what can be done with the additional $3,350 freed up if project A is chosen. If

Unk’s Farms can earn more on project A, plus the project financed with the

additional $3,350, than it can on project B, then project A and the marginal

project should be accepted.

9-12A. a. Payback A = 3.125 years

Payback B = 4.5 years

B assumes even cash flow throughout year 5.

5 $16,000

b. NPVA = ∑ - $50,000

t = 1 (1 + 0.11)

t

= $59,136 - $50,000

= $9,136

318

$100,000

NPVB = - $50,000

(1 + 0.11) 5

= $100,000 (0.593) - $50,000

= $59,300 - $50,000

= $9,300

c. $50,000 = $16,000 [PVIFAIRR %,5 yrs]

A

3.125 = PVIFAIRR %,5 yrs

A

Thus, IRRA = 18%

$50,000 = $100,000 [PVIFIRR %,5 yrs]

B

.50 = PVIFIRR %,5 yrs

B

Thus, IRRB is just under 15%.

d. The conflicting rankings are caused by the differing reinvestment assumptions

made by the NPV and IRR decision criteria. The NPV criteria assume that cash

flows over the life of the project can be reinvested at the required rate of return or

cost of capital, while the IRR criterion implicitly assumes that the cash flows over

the life of the project can be reinvested at the internal rate of return.

e. Project B should be taken, because it has the largest NPV. The NPV criterion is

preferred because it makes the most acceptable assumption for the wealth-

maximizing firm.

9-13A. a. Payback A = 1.5385 years

Payback B = 3.0769 years

3 $13,000

b. NPVA = ∑ - $20,000

t = 1 (1 + 0.14 )

t

= $30,186 - $20,000

= $10,186

9 $6,500

NPVB = ∑ - $20,000

t = 1 (1 + 0.14 )

t

= $32,149 - $20,000

= $12,149

319

c. $20,000 = $13,000 [PVIFAIRR %,3 yrs]

A

Thus, IRRA = over 40% (42.75%)

$20,000 = $6,500 [PVIFAIRR %,9 yrs]

B

Thus, IRRB = 29%

d. These projects are not comparable, because future profitable investment proposals

are affected by the decision currently being made. If project A is taken, at its

termination, the firm could replace the machine and receive additional benefits,

while acceptance of project B would exclude this possibility.

e. Using 3 replacement chains, project A’s cash flows would become:

Year Cash flow

0 -$20,000

1 13,000

2 13,000

3 - 7,000

4 13,000

5 13,000

6 - 7,000

7 13,000

8 13,000

9 13,000

9 $13,000 $20,000 $20,000

NPVA = ∑ - $20,000 - -

t = 1 (1 + 0.14 )

t

(1 + 0.14) 3 (1 + 0.14) 6

= $13,000(4.946) - $20,000 - $20,000 (0.675)

- $20,000 (0.456)

= $64,298 - $20,000 - $13,500 - $9,120

= $21,678

The replacement chain analysis indicated that project A should be selected since the

replacement chain associated with it has a larger NPV than project B.

Project A’s EAA:

Step 1: Calculate the project’s NPV (from part b):

NPVA = $10,186

Step 2: Calculate the EAA:

EAAA = NPV / PVIFA14%, 3 yr.

= $10,186 / 2.322

= $4,387

Project B’s EAA:

Step 1: Calculate the project’s NPV (from part b):

NPVB = $12,149

320

Step 2: Calculate the EAA:

EAAB = NPV / PVIFA14%, 9 yr.

= $12,149 / 4.946

= $2,256

Project B should be selected because it has a higher EAA.

9-14A. a. Project A’s EAA:

Step 1: Calculate the project’s NPV:

NPVA = $20,000 (PVIFA10%, 7 yr.) - $40,000

= $20,000 (4.868) - $40,000

= $97,360 - $40,000

= $57,360

Step 2: Calculate the EAA:

EAAA = NPV / PVIFA10%, 7 yr.

= $57,360 / 4.868

= $11,783

Project B’s EAA:

Step 1: Calculate the project’s NPV:

NPVB = $25,000 (PVIFA10%, 5 yr.) - $40,000

= $94,775 - $40,000

= $54,775

Step 2: Calculate the EAA:

EAAB = NPV / PVIFA10%, 5 yr.

= $54,775 / 3.791

= $14,449

Project B should be selected because it has a higher EAA.

b. NPV∞,A = $11,783 / .10

= $117,830

NPV∞,B = $14,449 / .10

= $144,490

321

9-15A. a.

Present Value

Profitability of Future

Project Cost Index Cash Flows NPV

A $4,000,000 1.18 $4,720,000 $ 720,000

B 3,000,000 1.08 3,240,000 240,000

C 5,000,000 1.33 6,650,000 1,650,000

D 6,000,000 1.31 7,860,000 1,860,000

E 4,000,000 1.19 4,760,000 760,000

F 6,000,000 1.20 7,200,000 1,200,000

G 4,000,000 1.18 4,720,000 720,000

A&B $ 7,000,000 $ 960,000

A&C 9,000,000 2,370,000

A&D 10,000,000 2,580,000

A&E 8,000,000 1,480,000

A&F 10,000,000 1,920,000

A&G 8,000,000 1,440,000

B&C 8,000,000 1,890,000

B&D 9,000,000 2,100,000

B&E 7,000,000 1,000,000

B&F 9,000,000 1,440,000

B&G 7,000,000 960,000

C&D 11,000,000 3,510,000

C&E 9,000,000 2,410,000

C&F 11,000,000 2,850,000

C&G 9,000,000 2,370,000

D&E 10,000,000 2,620,000

D&F 12,000,000 3,060,000

D&G 10,000,000 2,580,000

E&F 10,000,000 1,960,000

E&G 8,000,000 1,480,000

F&G 10,000,000 1,920,000

A&B&C 12,000,000 2,610,000

A&B&E 11,000,000 1,720,000

A&B&G 11,000,000 1,680,000

A&E&G 12,000,000 2,200,000

B&C&E 12,000,000 2,650,000

B&C&G 12,000,000 2,610,000

Thus, projects C&D should be selected under strict capital rationing as they provide the

combination of projects with the highest net present value.

b. Because capital rationing forces the rejection of profitable projects, it is not an

optimal strategy.

322

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