Concept Questions and Exercises CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

CHAPTER4
INVESTMENT CRITERIAS
1. Calculating Payback Period and NPV Maxwell Software, Inc., has the following mutually
exclusive projects.

The payback period for a project refers to the time period in which the cost of the investment can be
recovered. 
Year Project A Cumulative Cash Inflow
1 13,200 13,200
2 8,300 21,500
3 3,200
From the above calculations, we see that at the end of the second year the total cash inflow
generated from project A is $21,500. We see that the cost of project A is $20,000 can be recovered
after 1st year but earlier than 2nd year.
Therefore we interpolate between first and second year
Payback period =1+ (20,000 – 13,200)/8,300 = 1 + 0,8193 = 1,8193 years
Year Project B Cumulative Cash Inflow
1 14,100 14,100
2 9,800 23,900
3 7,600 31,500
From the above calculations, we see that at the end of the third year the total cash inflow generated
from project B is $23,900. We see that the cost of project B is $24,000 can be recovered after the
2nd year but earlier than the 3rd year.
Therefore we interpolate between the second and third year
Payback period = 1+ (24,000 – 23,900)/7,600 = 1 + 0,0132 = 1,0132 years
a. Suppose the company’s payback period cutoff is two years. Which of these two projects
should be chosen?
A project with a shorter payback period is preferred. On comparing projects A and B we see
that Project B has a shorter payback period. Therefore we prefer project B.
Concept Questions and Exercises CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

b. Suppose the company uses the NPV (net present value) rule to rank these two projects.
Which project should be chosen if the appropriate discount rate is 15 percent?

NPV of project A=13200/(1+0,15) + 8300/(1+0,15)^2 + 3200/(1+0.15)^3 - 20000 = - 141.69 <0

NPV of project B= 14100/(1+0,15) + 9800/(1+0,15)^2 + 7600/(1+0.15)^3 - 24000 = 668.2 > 0
=> Because project B has a positive NPV so choose project B

2. Calculating Discounted Payback An investment project has annual cash inflows of $5,000,
$5,500, $6,000, and $7,000, and a discount rate of 12 percent. What is the discounted payback
period for these cash flows if the initial cost is $8,000? What if the initial cost is $12,000? What if
it is $16,000?

Discounted Payback Period = Year before the discounted payback period occurs + cummulative
cash flow in year before recovery/ discounted cash flow in year after recovery

Year PV factor working PV factor at 12% Cash flow PV Cummulative

PV
0 1/(1+0,12)^0 1 -8000 1*(-8000)=-8000 -8000
1 1/(1+0,12)^1 0,8929 5000 4464.29 -8000+4464.29
= -3535.71
2 1/(1+0,12)^2 0,7972 5500 4384.57 848.85
3 1/(1+0,12)^3 0,7118 6000 4270.68 5119.53
4 1/(1+0,12)^4 0,6355 7000 4448.63 9568.16
 DPP for project 1 = 1 + (3535.71/4384.57) = 1,81 years

Year PV factor at 12% PV factor working Cash flow PV Cummulative

PV

0 1 1/(1+0,12)^0 -12000 1*(-12000) -12000

Concept Questions and Exercises CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

= -12000
1 0,8929 1/(1+0,12)^1 5000 4464.29 -12000+4464.29
= -7535.71
2 0,7972 1/(1+0,12)^2 5500 4384.57 -3151.15
3 0,7118 1/(1+0,12)^3 6000 4270.68 1119.53
4 0,6355 1/(1+0,12)^4 7000 4448.63 5568.16
 DPP for project 2 = 2 + (3151.15/4270.68) = 2.74 years
Year PV factor at 12% PV factor working Cash flow PV Cummulative
PV

0 1 1/(1+0,12)^0 -16000 1*(-12000) -16000

= -16000
1 0,8929 1/(1+0,12)^1 5000 4464.29 -16000+4464.29
= -11535.71
2 0,7972 1/(1+0,12)^2 5500 4384.57 -7151.15
3 0,7118 1/(1+0,12)^3 6000 4270.68 -2880.47
4 0,6355 1/(1+0,12)^4 7000 4448.63 1568.16
 DPP for project 3 = 3 + (2880.47/4448.63) = 3.65 years

3. Calculating IRR Compute the internal rate of return for the cash flows of the following two
projects:

IRR (Internal Rate of Return) : IRR Means with a particular Percentage rate , At that point the present value
become the zero

IRR of project A is:

2750 + 2800 + 1600 - 5700 = 0
¿¿ ¿¿ ¿¿
=> IRR= 0,1339 = 13,39%
IRR of project B is:
1380 + 1800 + 1200 - 3450 = 0
¿¿ ¿¿ ¿¿
=> IRR= 0,1321 = 13,21%
Concept Questions and Exercises CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

4. Calculating Profitability Index Bill plans to open a self-serve grooming center in storefront.
The grooming equipment will cost $265,000, to be paid immediately. Bill expects after tax cash
inflows of $59,000 annually for seven years, after which he plans to scrap the equipment and retire
to the beaches of Nevis. The first cash inflow occurs at the end of the first year. Assume the
required return is 13 percent. What is the project’s PI? Should it be accepted?
PI: Profitability Index
Initial investment $265,000
Cash inflow per year $59,000
Period 7 years
Required rate of return 13%
Cash flow of the project can be represented as follows
Year 0 1 2 3 4 5 6 7
Cash ($265,000) $59,000 $59,000 $59,000 $59,000 $59,000 $59,000 $59,000
flow

Profitability index can be calculated as follows:

PI (Profitability index) = PV (Present Value) of future cashflows / Initial Investment
Present Value of future cash flows = Annual cash inflow * PVIFA for 7 years at 13%

PVIFA (Present value interest factor annuity)

 PVIFA= 1 – (1/(1+0.13)^7) / 0.13 = 4.4226
 Present Value of future cash flows = 59,000 * 4.4226 = $260,933.4
So the profitability index = 260,933.4/265,000 = 0.9847 < 1
=> the project's PV is less than the initial investment → the project should be rejected

5. NPV versus IRR Consider the following cash flows on two mutually exclusive projects for the
Bahamas Recreation Corporation (BRC). Both projects require an annual return of 14 percent.
Concept Questions and Exercises CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

b
As a financial analyst for BRC, you are asked the following questions:
a. If your decision rule is to accept the project with the greater IRR, which project should you
choose?
IRR (Internal Rate of Return) : IRR Means with a particular Percentage rate , At that point the present value
become the zero
Calculation of IRR of Projects:
IRR of Deepwater Fishing (A):
320,000/(1+IRR) + 470,000/(1+IRR)^2 + 410,000/(1+IRR)^3 – 850,000 = 0
=> IRR=0.185 => IRR of Deepwater Fishing = 18.5%
IRR of New Submarine Ride (B):
810,000/(1+IRR) + 750,000/(1+IRR)^2 + 690,000/(1+IRR)^3 - 1,650,000 = 0
=> IRR=0.178 => IRR of New Submarine Ride = 17.8%
=> Should chosen Deepwater Fishing

b. Because you are fully aware of the IRR rule’s scale problem, you calculate the incremental IRR
for the cash flows. Based on your computation, which project should you choose?

Project 0 1 2 3 IRR

B-A -800,000 490,000 280,000 280,000 16.84%

IRR = 490/(1+IRR) + 280/(1+IRR)^2 + 280/(1+IRR)^3 – 800 = 0
<=> 800IRR^3 +1910IRR^2 + 1140IRR – 250 = 0
<=> IRR = 0.1684 => IRR=16.84%
Because 16.84% > 14% so choose B is New Submarine Ride Project

c. To be prudent, you compute the NPV for both projects. Which project should you choose? Is it
consistent with the incremental IRR rule?
NPV of A = 320,000/(1+0.14) + 470,000/1+0.14)^2 + 410,000/(1+0.14)^3 – 850,000 = 69089.81
NPV of B = 810,000/(1+0.14) + 750,000/(1+0.14)^2 + 690,000/(1+0.14)^3 – 1,650,000 =
103357.3083
Concept Questions and Exercises CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

=> NPV of B is higher so it should be selected

Yes, it true because the IRR on the incremental investment B - A is 16.8% > 14%

6. Comparing Investment Criteria Wii Brothers, a game manufacturer, has a new idea for an
adventure game. It can market the game either as a traditional board game or as an interactive DVD,
but not both. Consider the following cash flows of the two mutually
exclusive projects for the company. Assume the discount rate for both projects is 10 percent.

a. Based on the payback period rule, which project should be chosen?

Payback period is the time taken to recover the initial investment from the CFs of the project:

Discounted payback period = Year before the discounted payback period occurs + Cummulative
cash flow in year before recovery/ discounted cash flow in year after recovery

Board game
Year CF DCF Cumulative CF

0 -950 -950 -950

1 700 700/(1+10%)^1=636.36 -313.64

2 550 454.54 140.9

3 130 97.67 238.59
DPP of board game= 1+ 313.64/454.54 =1.69 year

DVD
Yea CF DCF Cumulative CF
r
0 -2100 -2100 -2100
Concept Questions and Exercises CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

1 1500 1363.63 -736.37

2 1050 867.76 131.39

3 450 338.09 469.48
DPP of DVD = 1 + 735.37/867.76 = 1.84 year
=> Because the DPP of Board game is lower than DPP of DVD => should choose Board game

b. Based on the NPV Net Present Value, which project should be chosen?

NPV is calculated below:

700
NPV of board game = + 550 + 130 - 950 = 238,58
(1+10 %) ¿ ¿ ¿¿
1500
NPV of DVD = + 1050 + 450 - 2100 = 469,49
(1+10 %) ¿¿ ¿¿
 NPV of DVD is higher so it should be selected

c. Based on the IRR, which project should be chosen?

IRR of board game = 700 + 550 + 130 - 950 = 0,275 = 27,5%

¿¿ ¿¿ ¿¿

IRR of DVD = 1500 + 1050 + 450 - 2100 = 0,2509 = 25,09 %

¿¿ ¿¿ ¿¿
=> Should choose board game

d. Based on the incremental IRR, which project should be chosen?

We first find the incremental CF
Concept Questions and Exercises CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

Yea
r CF DVD CF Board game Incremental CF = CF DVD - CF Board game

0 $ -2,100 $ -950 $-1150

1 $   1,500 $700 $800

2 $   1,050 $550 $500

3 $    450 $130 $320

The incremental IRR = 800 + 500 + 320 - 1150 = 0,2319 = 23,19% > 10%
¿¿ ¿¿ ¿¿
=> Should choose DVD

7. Profitability Index versus NPV Hanmi Group, a consumer electronics conglomerate, is

reviewing its annual budget in wireless technology. It is considering investments in three different
technologies to develop wireless communication devices. Consider the following cash flows of the
three independent projects available to the company. Assume the discount rate for all projects is 10
percent. Further, the company has only $40 million to invest in new projects this year.

a. Based on the profitability index decision rule, rank these investments.

PV = CF/(1+r)^t
Profitability index = Present Value of future cashflows / Initial Investment
22 15 5
PV of CDMA = + 2+ = 36,1533
(1+10 %) (1+10 %) (1+10 %)3
3 6,1533
PI of CDMA= = 2.2596
16

20 50 40
PV of G4 = + 2+ = 89,5567
(1+10 %) (1+10 %) (1+10 %)3
89,55 67
PI of G4 = = 3,7315
24
Concept Questions and Exercises CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

36 64 40
PV of Wifi = + 2+ = 115,67
(1+10 %) (1+10 %) (1+10 %)3
115,67
PI of Wifi = = 2,89
40
=> Rank the projects: G4 - Wifi - CDMA

b. Based on the NPV, rank these investments.

NPV of CDMA: 36,1533-16= 20,153

NPV of G4: 89,5567 - 24 = 65,5567
NPV of Wifi : 115,67 - 40 = 75,67
=> Rank the project: Wifi - G4 - CDMA

c. Based on your findings in (a) and (b), what would you recommend to the CEO of the company
and why?
Base on the company has only $40 million to invest in new projects this year, I would recommend
the CEO to take the both the CDMA and G4 project

8. NPV and Multiple IRRs You are evaluating a project that costs $75,000 today. The project has
an inflow of $155,000 in one year and an outflow of $65,000 in two years. What are the IRRs for the
project? What discount rate results in the maximum NPV for this project? How can you determine
that this is the maximum NPV?

IRR for project is the rate of return at which NPV is zero

0 = -75,000 + 155,000/(1+IRR) – 65,000/(1+IRR)^2 <=> 5IRR – 75IRR^2 + 15=0 => IRR = 0.482
Concept Questions and Exercises CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

Let us assume X= 1/(1+R)

NPV = -65,000X^2 + 155,000X – 75,000
NPV’ = -130,000X + 155,000=0 ⇔ X= 1.1923 = 1/(1+R) ⇔ R = -0.16 (1)
NPV” = -130,000 < 0 (2)
(1), (2) => maximum NPV in R = - 0.16

9. Payback and NPV An investment under consideration has a payback of six years and a cost of
$573,000. If the required return is 12 percent, what is the worst-case NPV? The best-case NPV?
Explain. Assume the cash flows are conventional.

The worst- case NPV= 573,000/1.12^6 – 573,000 = -282700.37

In the best case PV has infinite CF
The best- case NPV = infinite

10. Calculating IRR Consider two streams of cash flows, A and B. Stream A’s first cash flow is
$11,600 and is received three years from today. Future cash flows in Stream A grow by 4 percent in
perpetuity. Stream B’s first cash flow is -$13,000, is received two years from today, and will
continue in perpetuity. Assume that the appropriate discount rate is 12 percent.

a. What is the present value of each stream?

PV2 of A=CF/(r-g) = 11600/(0.12 - 0.04)= 145000
=> PV0 of A= 145000/(1+0.12)^2= 115593.1122
PV1 of B= 13000/0.12 = 108333
=> PV0 of B = 108333/1.12= 96725.89
Concept Questions and Exercises CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

b. Suppose that the two streams are combined into one project, called C. What is the IRR
of Project C?
c. What is the correct IRR rule for Project C?