Handout 5 (Chapter 9)

Questions and Problems

Page 311

BASIC
(Q uestions 1–19)
1. Calculating Payback [ LO2] What is the payback period for the following set of cash flows?
Year Cash Flow

0 −$7,700
1 1,900
2 3,000
3 2,300
4 1,700

2. Calculating Payback [ LO2] An investment project provides cash inflows of $835 per year
for eight years. What is the project payback period if the initial cost is $1,900? What if the
initial cost is $3,600? What if it is $7,400?
3. Calculating Payback [ LO2] Kara, Inc., imposes a payback cutoff of three years for its
international investment projects. If the company has the following two projects available,
should it accept either of them?
Year Cash Flow (A) Cash Flow (B)

0 −$40,000 −$ 55,000
1 14,000 11,000
2 18,000 13,000
3 17,000 16,000
4 11,000 255,000

4. Calculating Discounted Payback [ LO3] An investment project has annual cash inflows of
$2,800, $3,700, $5,100, and $4,300, for the next four years, respectively. The discount rate is 9
percent. What is the discounted payback period for these cash flows if the initial cost is $5,200?
What if the initial cost is $6,400? What if it is $10,400?
5. Calculating Discounted Payback [ LO3] An investment project costs $19,000 and has annual
cash flows of $5,100 for six years. What is the discounted payback period if the discount rate is
zero percent? What if the discount rate is 5 percent? If it is 19 percent?
6. Calculating AAR [ LO4] You’re trying to determine whether to expand your Page 312
business by building a new manufacturing plant. The plant has an installation cost of
 $12.6 million, which will be depreciated straight-line to zero over its four-year life. If
the plant has projected net income of $1,430,000, $1,523,460, $1,716,300, and
$1,097,400 over these four years, respectively, what is the project’s average accounting
return (AAR)?
7. Calculating IRR [ LO5] A firm evaluates all of its projects by applying the IRR rule.
If the required return is 14 percent, should the firm accept the following project?
Year Cash Flow

0 −$41,000
1 20,000
2 23,000
3 14,000

8. Calculating NPV [ LO1] For the cash flows in the previous problem, suppose the firm uses
the NPV decision rule. At a required return of 11 percent, should the firm accept this project?
What if the required return is 24 percent?
9. Calculating NPV and IRR [ LO1, 5] A project that provides annual cash flows of $15,300
for nine years costs $74,000 today. Is this a good project if the required return is 8 percent?
What if it’s 20 percent? At what discount rate would you be indifferent between accepting the
project and rejecting it?
10. Calculating IRR [ LO5] What is the IRR of the following set of cash flows?
Year Cash Flow

0 −$18,700
1 9,400
2 10,400
3 6,500

11. Calculating NPV [ LO1] For the cash flows in the previous problem, what is the NPV at a
discount rate of zero percent? What if the discount rate is 10 percent? If it is 20 percent? If it
is 30 percent?
12. NPV versus IRR [ LO1, 5] Bruin, Inc., has identified the following two mutually exclusive
projects:
Year Cash Flow (A) Cash Flow (B)

0 −$41,300 −$41,300
1 19,100 6,300
2 17,800 14,200
3 15,200 17,900
4 8,400 30,300

a. What is the IRR for each of these projects? Using the IRR decision rule, which project should
the company accept? Is this decision necessarily correct?
 b. If the required return is 11 percent, what is the NPV for each of these projects? Which project
will the company choose if it applies the NPV decision rule?
c. Over what range of discount rates would the company choose Project A? Project B? At what
discount rate would the company be indifferent between these two projects? Explain.
13. NPV versus IRR [ LO1, 5] Consider the following two mutually exclusive projects: Page 313

Year Cash Flow (X) Cash Flow (Y)

0 −$30,000 −$30,000
1 13,700 15,600
2 14,200 12,200
3 13,400 13,300
Sketch the NPV profiles for X and Y over a range of discount rates from zero to 25 percent.
What is the crossover rate for these two projects?
14. Problems with IRR [ LO5] Howell Petroleum, Inc., is trying to evaluate a generation project
with the following cash flows:
Year Cash Flow

0 −$52,000,000
1 74,000,000
2 − 12,000,000

a. If the company requires a return of 12 percent on its investments, should it accept this
project? Why?
b. Compute the IRR for this project. How many IRRs are there? Using the IRR decision rule,
should the company accept the project? What’s going on here?
15. Calculating Profitability Index [ LO7] What is the profitability index for the following set of
cash flows if the relevant discount rate is 10 percent? What if the discount rate is 15 percent?
If it is 22 percent?
Year Cash Flow

0 −$14,800
1 8,400
2 7,600
3 4,300

16. Problems with Profitability Index [ LO1, 7] The Michner Corporation is trying to choose
between the following two mutually exclusive design projects:
Year Cash Flow (I) Cash Flow (II)
 Year Cash Flow (I) Cash Flow (II)

0 −$82,000 −$21,700
1 37,600 11,200
2 37,600 11,200
3 37,600 11,200

a. If the required return is 10 percent and the company applies the profitability index decision
rule, which project should the firm accept?
b. If the company applies the NPV decision rule, which project should it take?
c. Explain why your answers in parts (a) and (b) are different.

17. Comparing Investment Criteria [ LO1, 2, 3, 5, 7] Consider the following Page 314
two mutually exclusive projects:
Year Cash Flow (A) Cash Flow (B)

0 −$291,000 −$41,600
1 37,000 20,000
2 55,000 17,600
3 55,000 17,200
4 366,000 14,000
Whichever project you choose, if any, you require a return of 11 percent on your investment.
a. If you apply the payback criterion, which investment will you choose? Why?
b. If you apply the discounted payback criterion, which investment will you choose? Why?
c. If you apply the NPV criterion, which investment will you choose? Why?
d. If you apply the IRR criterion, which investment will you choose? Why?
e. If you apply the profitability index criterion, which investment will you choose? Why?
f. Based on your answers in parts (a) through (e), which project will you finally choose? Why?

18. NPV and Discount Rates [ LO1] An investment has an installed cost of $574,380. The cash
flows over the four-year life of the investment are projected to be $216,700, $259,300,
$214,600, and $167,410, respectively. If the discount rate is zero, what is the NPV? If the
discount rate is infinite, what is the NPV? At what discount rate is the NPV just equal to zero?
Sketch the NPV profile for this investment based on these three points.
19. MIRR [ LO6] Duo Corp. is evaluating a project with the following cash flows:
Year Cash Flow

0 −$53,000
1 16,700
2 21,900
3 27,300
4 20,400
5 − 8,600
Handout 6 (Chapter 10)

Questions and Problems

Basic ( Questions 1– 20)

1. Relevant Cash Flows [ LO1] Parker & Stone, Inc., is looking at setting up a new Page 348
manufacturing plant in South Park to produce garden tools. The company bought some
land six years ago for $2.8 million in anticipation of using it as a warehouse and
distribution site, but the company has since decided to rent these facilities from a
competitor instead. If the land were sold today, the company would net $3.2 million.
The company wants to build its new manufacturing plant on this land; the plant will
cost $14.3 million to build, and the site requires $825,000 worth of grading before it is
suitable for construction. What is the proper cash flow amount to use as the initial
investment in fixed assets when evaluating this project? Why?
2. Relevant Cash Flows [ LO1] Winnebagel Corp. currently sells 20,000 motor homes per
year at $103,000 each and 14,000 luxury motor coaches per year at $155,000 each. The
company wants to introduce a new portable camper to fill out its product line; it hopes
to sell 25,000 of these campers per year at $19,000 each. An independent consultant
has determined that if the company introduces the new campers, it should boost the
sales of its existing motor homes by 2,700 units per year and reduce the sales of its
motor coaches by 1,300 units per year. What is the amount to use as the annual sales
figure when evaluating this project? Why?
3. Calculating Projected Net Income [ LO1] A proposed new investment has projected
sales of $515,000. Variable costs are 36 percent of sales, and fixed costs are $173,000;
depreciation is $46,000. Prepare a pro forma income statement assuming a tax rate of
21 percent. What is the projected net income?
4. Calculating OCF [ LO1] Consider the following income statement:
$704,600
Sales
527,300
Costs
82,100
Depreciation
?
EBIT
Taxes (22%)
?
Net income
?
Fill in the missing numbers and then calculate the OCF. What is the depreciation tax shield?
5. OCF from Several Approaches [ LO1] A proposed new project has projected sales of
$215,000, costs of $104,000, and depreciation of $25,300. The tax rate is 23 percent.
Calculate operating cash flow using the four different approaches described in the chapter and
verify that the answer is the same in each case.
6. Calculating Depreciation [ LO1] A piece of newly purchased industrial equipment costs
$1.475 million and is classified as seven-year property under MACRS. Calculate the annual
depreciation allowances and end-of-the-year book values for this equipment.
7. Calculating Salvage Value [ LO1] Consider an asset that costs $745,000 and is Page 349
depreciated straight-line to zero over its eight-year tax life. The asset is to be used in a
five-year project; at the end of the project, the asset can be sold for $135,000. If the
relevant tax rate is 21 percent, what is the aftertax cash flow from the sale of this
asset?
8. Calculating Salvage Value [ LO1] An asset used in a four-year project falls in the five-
year MACRS class for tax purposes. The asset has an acquisition cost of $5.7 million
and will be sold for $1.8 million at the end of the project. If the tax rate is 21 percent,
what is the aftertax salvage value of the asset?
9. Calculating Project OCF [ LO1] Esfandairi Enterprises is considering a new three-
year expansion project that requires an initial fixed asset investment of $2.18 million.
The fixed asset will be depreciated straight-line to zero over its three-year tax life, after
which time it will be worthless. The project is estimated to generate $1.645 million in
annual sales, with costs of $610,000. If the tax rate is 21 percent, what is the OCF for
this project?
10. Calculating Project NPV [ LO1] In the previous problem, suppose the required
return on the project is 12 percent. What is the project’s NPV?
11. Calculating Project Cash Flow from Assets [ LO1] In the previous problem, suppose
the project requires an initial investment in net working capital of $250,000, and the
fixed asset will have a market value of $180,000 at the end of the project. What is the
project’s Year 0 net cash flow? Year 1? Year 2? Year 3? What is the new NPV?
12. NPV and MACRS [ LO1] In the previous problem, suppose the fixed asset actually
falls into the three-year MACRS class. All the other facts are the same. What is the
project’s Year 1 net cash flow now? Year 2? Year 3? What is the new NPV?
13. NPV and Bonus Depreciation [ LO1] In the previous problem, suppose the fixed
asset actually qualifies for 100 percent bonus depreciation in the first year. All the
other facts are the same. What is the project’s Year 1 net cash flow now? Year 2? Year
3? What is the new NPV?
14. Project Evaluation [ LO1] Dog Up! Franks is looking at a new sausage system with
an installed cost of $385,000. This cost will be depreciated straight-line to zero over
the project’s five-year life, at the end of which the sausage system can be scrapped for
$60,000. The sausage system will save the firm $135,000 per year in pretax operating
costs, and the system requires an initial investment in net working capital of $35,000.
If the tax rate is 21 percent and the discount rate is 10 percent, what is the NPV of
this project?
15. NPV and Bonus Depreciation [ LO1] In the previous problem, suppose the fixed
asset actually qualifies for 100 percent bonus depreciation in the first year. What is the
new NPV?
16. Project Evaluation [ LO1] Your firm is contemplating the purchase of a new
$535,000 computer-based order entry system. The system will be depreciated straight-