Investment Evaluation

Part 1 Introduction to Financial Management Part 4 Capital Structure and Dividend Policy
(Chapters 1, 2, 3, 4) (Chapters 15, 16)
Part 2 Valuation of Financial Assets Part 5 Liquidity Management and Special Topics
(Chapters 5, 6, 7, 8, 9, 10) in Finance (Chapters 17, 18, 19, 20)
Part 3 Capital Budgeting (Chapters 11, 12, 13, 14)

11C H A P T E R
Investment Decision Criteria
Chapter Outline
11.1 An Overview of Capital Objective 1. Understand how to identify the sources
and types of profitable investment opportunities.
Budgeting (pgs. 362–364)
11.2 Net Present Value Objective 2. Evaluate investment opportunities using

the net present value and describe why it is the best
(pgs. 364–372)
measure to use.
11.3 Other Investment Criteria Objective 3. Use the profitability index, internal rate of
return, and payback criteria to evaluate investment
(pgs. 372–387)
opportunities.
11.4 A Glance at Actual Capital- Objective 4. Understand current business practice

with respect to the use of capital-budgeting criteria.
Budgeting Practices
(pgs. 387–389)
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Principles P 1, P 2, P 3, and P 5 Applied
This chapter applies what we have learned from valuing stocks and Tradeoff—different investment opportunities have different levels
bonds to the valuation of investments in production plants, new of risk, and as a result, the risk-return tradeoff becomes important
equipment, real estate, and any other asset that is likely to generate when determining the rate to use to discount future cash flows; P
future profits. Our discussion of valuing investment opportunities Principle 3: Cash Flows Are the Source of Value—when evaluating
relies on the first three basic principles of finance, along with the fi- investment opportunities, we will rely on the cash flows generated
nal principle: P Principle 1: Money Has a Time Value—the cash by the investment rather than accounting profits; and P Principle 5:
inflows and outflows from an investment opportunity are generally Individuals Respond to Incentives—managers respond to incen-
spread out over a number of years; thus, we need the time-value-of- tives, and when their investment incentives are not properly aligned
money tools to make these cash flows that occur in different time with those of the firm’s stockholders, they may not make the invest-
periods comparable; P Principle 2: There Is a Risk-Return ments that are consistent with increasing shareholder value.
Real Estate
Investing
Suppose that you and your roommates rent a
condo near campus and, at the end of your senior
year, your landlord offers to sell you the condo for
$90,000. If you bought the condo, you would make
some minor repairs and sell it right away. Your fa-
ther has agreed to loan you the money for the pur-
chase and repairs. How would you decide whether
to take your landlord up on the offer?
You estimate that it will cost $2,000 and take
about three weeks to get the condo repainted and ready for sale. Given the demand for student housing in the
area, you think that you will be able to sell it in a few days for $100,000, which represents a profit of $8,000.
By completing this analysis, you’ve just determined the net present value of this project, which is the $8,000
increase in your wealth that results from the purchase and sale of the condo.
This scenario is not unlike many investment problems in the world of corporate finance. A firm’s manager who is
considering a new investment, such as the launch of a new product, first analyzes the costs involved. Next, the man-
ager forecasts the future cash inflows expected throughout the life of the product. Our condo investment example
assumed that there is only three weeks from purchase to sale, so we ignored the time value of money, which in most
cases plays an important role. Hence, in the final step, the future cash flows of the investment must be discounted
back to the present and then compared to the initial cash outlay to determine whether the investment is likely to cre-
ate value for the investor. This will be the case if the present value of the cash inflows exceeds the initial cash outlay.
With the exception of the necessity of adjusting future cash flows for the time value of money, the analysis
carried out by the manager is exactly what you would have done in analyzing the condo investment. Very simply,
a good investment is one that is worth more than it costs to make. This observation is a good one to file away
and come back to over and over as we go through the rest of this chapter. Throughout the chapter, we will be
talking about the analysis of investment opportunities; the commonsense approach we will use is to compare the
benefits we derive from the investment with the costs we incur in making it.
Capital budgeting is the term we use to refer to the process used to evaluate a firm’s long-term investment
opportunities. As part of this process, managers rely on four of the basic principles of finance:
• First, we value an investment opportunity by evaluating its expected cash flows, following P Principle 3:
Cash Flows Are the Source of Value.
• Second, we discount all cash flows back to the present, taking into account P Principle 1: Money Has a Time Value.
361
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362 PART 3 | Capital Budgeting
• Next, we incorporate risk into the analysis by adjusting the discount rate used to calculate the present value
of the project’s future cash flows, bearing in mind P Principle 2: There Is a Risk-Return Tradeoff. The
term risk means that more things can happen than will happen, so the reward for assuming more risk is not
a sure thing but simply a higher expected return.
• Finally, we must take into account P Principle 5: Individuals Respond to Incentives. Managers respond
to incentives, and when their incentives are not properly aligned with those of the firm’s stockholders, they
may not make investment decisions that are consistent with increasing shareholder value.
We begin this chapter with a look at the criteria managers use to determine if an investment opportunity—
such as the condo investment or the product introduction—is a good investment. Our primary focus is on net
present value, a measure of the value created by the investment. However, we also review other popular mea-
sures used in practice.
Regardless of Your Major…
“
Making Personal Over your career, you will be faced with in-
vestment opportunities that require some type
Investment of evaluation and analysis. Whether the deci-
sion is to purchase a piece of property that
Decisions” you hope to develop and resell or to start and
run a business, capital-budgeting analysis will
help you make the right decision. In the introduction, we described a very simple real estate in-
vestment opportunity. More typically, such an investment would require a substantial investment
to improve the property, with renovations carried out over an extended period of time (perhaps
as much as a year). Having completed the renovation, you might consider at least two al-
ternatives: You could sell the property to someone else to rent and manage, or you could
keep the property and manage the rentals yourself. The tools we develop in this chapter will
help you evaluate the initial property investment as well as decide whether or not to keep and
manage the property.
Your Turn: See Study Question 11–1.
11.1 An Overview of Capital Budgeting

In 1955, the Walt Disney Company (DIS) was largely a movie studio, but that all changed
when the company decided to invest $17.5 million to build Disneyland in Anaheim, Califor-
nia. The decision to build the theme park was a major capital-budgeting decision for Disney
and was so successful that the company later decided to open theme parks in Orlando, Tokyo,
Paris, and Hong Kong. In retrospect, how important was this investment? Today, parks and
resorts account for over 30 percent of Disney’s revenue. There are three important lessons
from the Disney theme park story:
Lesson 1: C apital-budgeting decisions are critical in defining a company’s
business. Had Disney not embarked on its theme park strategy, it would be
a very different company today.
Lesson 2: Very large investments frequently consist of many smaller investment
decisions that define a business strategy. Disney did not launch its theme
parks in 1955 with a plan to invest $3.5 billion some 50 years later to build
the Hong Kong site. Rather, the $3.5 billion investment in the Hong Kong
Disneyland was the result of a series of smaller investments that led to the
eventual decision to expand the franchise in Asia.
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CHAPTER 11 | Investment Decision Criteria 363
Lesson 3: Successful investment choices lead to the development of managerial

expertise and capabilities that influence the firm’s choice of future in
vestments. Disney’s early success with its theme park in California
provided its managers with the expertise and confidence to replicate the
theme park in Orlando and then internationally. This storehouse of talent and
experience gives Disney a competitive edge on would-be competitors who
might seek to enter the theme park business.
The Typical Capital-Budgeting Process

Although the capital-budgeting process can be long and complicated at many major corporations,
we can sum up the typical capital-budgeting process at any firm in terms of two basic phases:
Phase 1: The firm’s management identifies promising investment opportunities.
These opportunities generally arise from ideas generated by the management
and employees of the firm. Employees who work closely with the firm’s cus-
tomers (generally, the marketing department) or who run the firm’s operations
(the production management department) are often the idea generators.
Phase 2: Once an investment opportunity has been identified, its value-creating
potential—what some refer to as its value proposition—is thoroughly
evaluated. In very simple terms, a project’s value proposition answers the
following question: “How do we plan to make money?” It is at this stage that
financial analysts enter the picture.
The logic of the two-phase process is very simple: Identify promising investment opportunities,
and select those that offer an opportunity to create value for the firm’s common stockholders.
What Are the Sources of Good Investment Projects?

Finding good investment projects can be a daunting task, particularly when the firm faces
substantial competition from other firms that are also looking for similar investment oppor-
tunities. Recall from your introductory economics class that firms tend to be more profitable
when they operate in markets that have less competition. So the search for good investments
is largely a search for opportunities where the firm can exploit some competitive advantage
over its competitors. For example, the firm may have a proprietary production process that
uses fewer inputs and results in a lower cost of production.
As a general rule, good investments are most likely to be found in markets that are less
competitive. These are markets where barriers to new entrants are sufficiently high that they
keep out would-be competitors. For example, the strong brand reputation of the Frito-Lay
products that results from an ongoing barrage of advertising makes it difficult for competing
brands to enter the salty snack food category and, at the same time, makes it easier for Frito-
Lay to introduce new products.
Types of Capital Investment Projects

Capital investment projects can be classified into one of three broad categories:
1. Revenue-enhancing investments
2. Cost-reducing investments
3. Mandatory investments that are a result of government mandates
Let’s consider each of these briefly.
Revenue-Enhancing Investments
Investments that lead to higher revenues often involve the expansion of existing businesses,
such as Apple’s (APPL) decision to add the smaller Nano to its iPod products. Alternatively,
when Apple originally decided to begin selling its iPod line of MP3 players, it created an
entirely new line of business.
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Larger firms have research and development (R&D) departments that search for ways to improve
existing products and create new ones. These ideas may come from within the R&D department or
be based on ideas from executives, sales personnel, or customers. The most common new investment
projects might involve taking an existing product and selling it to a new market. That was the case
when Kimberly-Clark (KMB), the manufacturer of Huggies, made its disposable diapers more
waterproof and began marketing them as disposable swim pants called Little Swimmers. Similarly,
the Sara Lee Corporation’s (SLE) hosiery unit appealed to more customers when it introduced Sheer
Energy pantyhose for support and Just My Size pantyhose aimed at larger-size customers.
Cost-Reducing Investments
The majority of a firm’s capital expenditure proposals are aimed at reducing the cost of doing business.
For example, Walmart (WMT) did not locate a regional distribution center in San Marcos, Texas, to
expand firm revenues; the region was already populated with Walmart stores. Instead, the primary
benefit of the distribution center came from lowering the cost of supporting stores within the region.
Other types of cost-reducing investments arise when equipment either wears out or
becomes obsolete due to the development of new and improved equipment. For example,
Intel’s (INTC) semiconductor manufacturing plants (called “fabs”) utilize equipment called
handlers that move microprocessors from one processing station to another and test their
functionality. Because the technology involved in the manufacture of these processors is
always evolving, the handlers also change and evolve. This means that Intel is continually
evaluating the replacement of existing equipment.
Mandated Investments
Companies frequently find that they must make capital investments to meet safety and envi-
ronmental regulations. These investments are not revenue-producing or cost-reducing but are
required for the company to continue doing business. An example is the scrubbers that are
installed on the smokestacks of coal-fired power plants. The scrubbers reduce airborne emis-
sions in order to meet government pollution guidelines.
Not all investments have sufficient potential for value creation to be undertaken, and we need
some analytical tools or criteria to help us ferret out the most promising investments. In the pages
that follow, we consider the most commonly used criteria for determining the desirability of alter-
native investment proposals. These include net present value (NPV), a closely related metric called
the equivalent annual cost (EAC), the profitability index (PI), the internal rate of return (IRR), the
modified internal rate of return (MIRR), the payback period, and the discounted payback period.
Before you move on to 11.2
Concept Check | 11.1

1. What does the term capital budgeting mean?
2. Describe the two-phase process typically involved in carrying out a capital-budgeting analysis.
3. What makes a capital-budgeting project a good one?
4. What are the three basic types of capital investment projects?
11.2 Net Present Value

In the introduction to this chapter, we described a simple investment opportunity involving
the purchase and sale of a condo. The $8,000 difference between the $100,000 cash inflow
from the sale of the condo and the $92,000 investment outlay (the $90,000 cost of buying the
condo from your landlord plus $2,000 in painting and repair expenses) is the incremental ef-
fect of the investment on your personal wealth. Because both the inflow from the sale and the
outflows related to buying and fixing up the condo were only three weeks apart, we ignored
the time value of money and compared the inflows directly to the outflows. We determined
that the investment is a sound undertaking because it can be sold for more than it cost.
The analysis of most investments requires us to also consider the time value of money.
In other words, instead of simply calculating the profits of the investment, we must calculate
the investment’s net present value. The net present value (NPV) is the difference between
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the present values of the cash inflows and the cash outflows. As such, the NPV estimates the
amount of wealth that the project creates. The NPV criterion simply states that an investment
project should be accepted if the NPV of the project is positive and should be rejected if the
NPV of the project is negative.1
Why Is the NPV the Right Criterion?

As we discussed in Chapter 1, one of the primary goals of a corporation is to improve the
wealth of its shareholders. Because the NPV of an investment measures the impact of the in-
vestment opportunity on the value of the firm, it is the gold standard of criteria for evaluating
new investment opportunities. However, the NPV is not the only investment criterion that is
used. So in addition to describing how the NPV is used to evaluate investment projects, we
will describe other criteria that are used in practice and compare each of them to the NPV
criterion.
Calculating an Investment’s NPV

Most investments that firms make are more complicated than the condo purchase and sale
described previously. Firms typically make investments that involve spending cash today with
the expectation of receiving cash over a period of several years. They may have a pretty good
idea as to how much these investments will cost; however, the expected future cash flows are
uncertain and must be discounted back to the present in order to estimate their value. Deter-
mining the appropriate discount rate, of what can be thought of as the required rate of return
or cost of capital for an investment is not easy, and in Chapter 14, we will look more carefully
at the calculation of this rate. In Chapter 12, we will delve into forecasting future cash flows
that are based on pro forma or predicted financial statements.
The NPV of an investment proposal can be defined as follows:
Cash Flow Cash Flow

Cash Flow
Net Present Cash Flow for Year 1 (CF1) for Year n (CFn)
for Year 2 (CF2)
= + + + g + (11–1)
Value (NPV) for Year 0 (CF0) Discount 1
Discount 2 Discount n
a1 + b a1 + b a1 + b
Rate (k) Rate (k) Rate (k)
¯˚˚˚˚˚˚˚˚˚˚˚˚˚˚˘˚˚˚˚˚˚˚˚˚˚˚˚˚˚˙
Cost of making the investment =
Initial cash flow (this is typically a cash Present value of the investment’s cash inflows =
outflow, taking on a negative value) Present value of the project’s future cash inflows
Once we calculate the NPV, we can make an informed decision about whether to accept
or reject the project. Reflecting back on our first three principles, you can see that they
are all reflected in the NPV: The project’s cash flows are used to measure the benefits the
project provides ( P Principle 3: Cash Flows Are the Source of Value), the cash flows are
discounted back to the present ( P Principle 1: Money Has a Time Value), and the discount
rate used to discount the cash flows back to the present reflects the risk in the future cash
flows ( P Principle 2: There Is a Risk-Return Tradeoff).
NPV Decision Criterion: If the NPV is greater than zero, the project will add value
and should be accepted, but if the NPV is negative, the project should be rejected.
If the project’s NPV is exactly zero (which is highly unlikely), the project will neither
create nor destroy value.
1
Note that projects that have a zero NPV earn the required rate of return used to discount the project cash flows and
technically are acceptable investments. However, given that we are estimating future cash flows, it is not uncommon
for firms to require an “NPV cushion” or a positive NPV. They accomplish this by adding a premium to the discount
rate. We discuss this idea further in Chapter 14, where we discuss the determination of the required rate of return or
cost of capital.
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Tools of Financial Analysis—Net Present Value

Name of Tool Formula What It Tells You
Net present Cash Flow Cash Flow • An estimate of the value added to
value (NPV) Cash Flow for Year 1 1CF12 for Year 2 1CF22 shareholder wealth if an investment is
NPV = + + undertaken.
for Year 0 1CF02 Discount 1 Discount 2 • In simple terms, the NPV represents the
a1 + b a1 + b
Rate 1k2 Rate 1k2 amount by which the value of the invest-
ment cash flows exceeds (or falls short
Cash Flow of) the cost of making an investment.
for Year n (CFn) • Thus, a good project is one that costs less
+ g +
Discount n than the value of its future cash flows—
a1 + b that is, one with a positive NPV.
Rate (k)
Independent Versus Mutually Exclusive

Investment Projects
The settings in which capital-budgeting analysis is carried out can vary. For example, there
are times when the firm is considering whether or not to make a single investment and other
times when it needs to analyze multiple investment opportunities simultaneously. In the first
case, the firm is evaluating what is referred to as an independent investment project. An inde-
pendent investment project is one that stands alone and can be undertaken without influenc-
ing the acceptance or rejection of any other project. For example, a firm may be considering
whether or not to construct a shipping and handling warehouse in central Kentucky. In the
second case, the firm is considering a group of mutually exclusive projects. Accepting a mu-
tually exclusive project prevents another project from being accepted. For example, a firm
may be interested in investing in an accounting software system and has two viable choices. If
the firm decides to take the first system, it cannot take the second system.
Evaluating an Independent Investment Opportunity
Project Long, evaluated in Checkpoint 11.1, demonstrates the use of the NPV to analyze an
independent investment opportunity. Because the project is an independent investment op-
portunity, its analysis entails simply calculating its NPV to see if it is positive or not. If the
NPV is positive, the investment opportunity adds value to the firm and should be undertaken.
Evaluating Mutually Exclusive Investment Opportunities

There are times when firms cannot undertake all positive-NPV projects. When this happens,
the firm must choose the best project or set of projects from the set of positive-NPV invest-
ment opportunities it has before it. Because the firm cannot undertake all of the positive-NPV
projects, they must be viewed as mutually exclusive. We will consider two such circumstances
in which the firm is faced with choosing from among a set of mutually exclusive projects:
1. Substitutes. When a firm is analyzing two or more alternative investments and each per-
forms the same function, the mutually exclusive alternatives are substitutes. For example,
a new pizza restaurant needs to buy a pizza oven. The managers consider a number of
alternatives, each of which, when viewed in isolation, has a positive NPV. However, they
need only one oven. Therefore, when analyzing which particular oven to buy, the pizza
restaurant’s managers are choosing between mutually exclusive alternatives.
2. Firm Constraints. The second reason for mutually exclusive investment opportunities
arises when the firm faces constraints that limit its ability to take every project that has a
positive NPV. Here are some situations where such constraints arise:
• Limited managerial time. The managers may have three projects that look attractive.
Although it might be possible to take on all three, the managers are very busy and feel that
only one project can be properly implemented at any given time.
• Limited financial capital. The managers may be reluctant to issue new equity or
to borrow substantial amounts of money from their bank, and as a result, they may
need to ration the capital that is readily available. If available investment funds are
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Checkpoint 11.1
Calculating the Net Present Value for Project Long

Project Long requires an initial investment of $100,000 and is expected to generate cash flows of $70,000 in Year 1,
$30,000 per year in Years 2 and 3, $25,000 in Year 4, and $10,000 in Year 5.
The discount rate (k) appropriate for calculating the NPV of Project Long is 17 percent. Is Project Long a good invest-
ment opportunity?
STEP 1: Picture the problem

Project Long requires an initial investment of $100,000 and is expected to produce the following cash flows over
the next five years:
k = 17%
Time Period 0 1 2 3 4 5 Years
Cash Flow –$100,000 $70,000 $30,000 $30,000 $25,000 $10,000
STEP 2: Decide on a solution strategy

Our strategy for analyzing whether this is a good investment opportunity involves first calculating the present value
of the cash inflows and then comparing them to the amount of money invested, the initial cash outflow, to see if the
difference or the NPV is positive. The NPV for Project Long is equal to the present value of the project’s expected
cash flows for Years 1 through 5 minus the initial cash outlay (CF0). We can use Equation (11–1) to solve this prob-
lem. Thus, the first step in the solution is to calculate the present value of the future cash flows by discounting the
cash flows using k = 17%. Then, from this quantity we subtract the initial cash outlay of $100,000.
We can calculate this present value using the mathematics of discounted cash flow, a financial calculator,
or a spreadsheet. We demonstrate all three methods here.
STEP 3: Solve
Using the Mathematical Formulas. Using Equation (11–1),
$70,000 $30,000 $30,000 $25,000 $10,000

NPV = -$100,000 + + + + +
(1 + .17)1 (1 + .17)2 (1 + .17)3 (1 + .17)4 (1 + .17)5
Solving the equation, we get
NPV = –$100,000 + $59,829 + $21,915 + $18,731 + $13,341 + $4,561
= –$100,000 + $118,378
= $18,378
Using a Financial Calculator. Before using the CF button, make sure you clear your calculator
by inputting CF; 2nd; CE/C.
Data and Key Input Display

CF; −100,000; ENTER CF0 5 −100,000.00
T ; 70,000; ENTER C01 5 70,000.00
T ; 1; ENTER F01 5 1.00
T ; 30,000; ENTER C02 5 30,000.00
T ; 2; ENTER F02 5 2.00
T ; 25,000; ENTER C03 5 25,000.00
T ; 1; ENTER F03 5 1.00
T ; 10,000; ENTER C04 5 10,000.00
T ; 1; ENTER F04 5 1.00
NPV; 17; ENTER I 5 17
T ; CPT NPV 5 18,378
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Using an Excel Spreadsheet. It should be noted that the NPV function in Excel does not compute the net
present value that we want to calculate. Instead, the NPV function calculates the present value of a sequence of
cash flows using a single discount rate. In addition, the NPV function assumes that the first cash flow argument
is for one period in the future (i.e., Period 1), so you do not want to incorporate the initial cash flow (CF0) in the
NPV function—instead, use the NPV function to calculate the present value of the cash flows, and then adjust
for the initial cash flow (CF0), which is generally a negative number. Specifically, the inputs of the NPV function
are the following for Project Long:
= NPV (discount rate, CF1, CF2, CF3, CF4, CF5) + CF0 or, with values entered, =
NPV (0.17,70000,30000,30000,25000,10000) - 100000 = $18,378

¯˚˚˚˚˘˚˚˚˚˙
And this answer will
Type this formula into a appear in the cell.
cell in a spreadsheet.
Thus, using the NPV function, we calculate the NPV of the investment to be $18,378.
STEP 4: Analyze
Project Long requires an initial investment of $100,000 and provides future cash flows that have a present value
of $118,378. Consequently, the project cash flows are $18,378 more than the required investment. Because
the project’s future cash flows are worth more than the initial cash outlay required to make the investment, the
project is an acceptable project.
STEP 5: Check yourself

Saber Electronics is considering providing specialty manufacturing services to defense contractors located in the
Seattle, Washington, area. The initial outlay is $3 million, and management estimates that the firm might generate
cash flows for Years 1 through 5 equal to $500,000, $750,000, $1,500,000, $2,000,000, and $2,000,000.
Saber uses a 20 percent discount rate for projects of this type. Is this a good investment opportunity?
ANSWER: NPV = $573,817.

Your Turn: For more practice, do the NPV calculations for Study Problems 11–1, 11–6, 11–8, 11–12, 11–19,
and 11–26 at the end of this chapter. >> END Checkpoint 11.1
limited to a fixed dollar amount that is less than the total amount of money required
to fund all positive-NPV projects, the firm will engage in capital rationing. This
means that the managers will need to choose between alternative investments that all
have positive NPVs.
In either of the above situations, one might think that the investment opportunity with
the highest NPV should be chosen. This intuition is often correct, but there are some impor-
tant exceptions. In particular, it is sometimes better to choose a project with a lower NPV
if the life of the project is shorter. With a shorter payback, the firm ties up its capital for
less time. Intuitively, one might think in terms of the NPV created per year as a metric for
evaluating a project. One might also want to choose projects that require less managerial
time and less capital.
Later in this chapter, we will describe popular alternative methods for evaluating invest-
ment projects in situations where firms must choose between mutually exclusive projects
because capital is rationed. In the Appendices in MyLab Finance, we consider an example
of a firm that must choose between two alternative investments that serve the same purpose.
Choosing Between Mutually Exclusive Investments

This section is relatively complex and can be skipped without loss of continuity. In fact,
many students find the material to be somewhat easier if they return to it after finishing the
chapter.
When comparing mutually exclusive investments that have the same useful life, we sim-
ply calculate the NPVs of the alternatives and choose the one with the higher NPV. However,
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it is often the case that mutually exclusive investments have different useful lives. For exam-
ple, one alternative might last for 10 years, while the other lasts only 6 years. This often occurs
when the firm is considering the replacement of a piece of equipment where the alternatives
have different initial costs to purchase, different useful lives, and different annual costs of
operations. The decision the firm must make is which alternative is most cost-effective.
Before we can decide which alternative to select, we must determine whether we will
need this piece of equipment forever. That is, at the end of its useful life, will we buy another
one? If not, we can simply compare alternatives with different lives by calculating the NPV
of each alternative and choosing the piece of equipment with the higher NPV. However, if we
expect this new piece of equipment to be replaced over and over again with a similar piece of
equipment with the same NPV for each replication of the investment, then we must calculate
the equivalent annual cost (EAC). The EAC is sometimes referred to as the equivalent annual
annuity (EAA). The EAC capital-budgeting technique provides an estimate of the annual cost
of owning and operating the investment over its lifetime. We can then compare the EACs of
two or more alternatives and select the most cost-effective alternative. The power of the EAC
is that it incorporates the time value of money, the initial cash outlay, and the productive life
of the investment all in a single number that can be compared across alternative investments.
The EAC of the equipment can be calculated as follows:
• First, we calculate the sum of the present values of the project’s costs, including the
project’s initial cost and the costs the firm will incur to operate the equipment over its
projected lifespan. Remember, in this case the revenues are the same for both of the alter-
natives we are considering, so the free cash flows for the alternative investments are all
negative (thus the name equivalent annual cost).
• Next, we convert the present value of the costs into its annual equivalent, which is the
EAC of the investment.
The EAC is simply the cost per year, and this is what we will use to compare the two
alternatives because the revenues are the same, regardless of which alternative is chosen.
You will notice that the calculations are the same as those we did earlier in Chapter 6 when
we calculated the installment payment on a loan (PMT). In this case, the EAC is the payment
(PMT) for an installment loan with the loan value amount (PV) equal to the present value of
the project’s costs. Thus, EAC can be calculated as follows:2
CF1 CF2 CFn

CF0 + + +g +
Equivalent PV of Costs (1 + k)1 (1 + k)2 (1 + k)n NPV
= = = (11–2)
Annual Cost (EAC) Annuity Present Value 1 1 1 1
a - b a - b
Interest Factor k k(1 + k)n k k(1 + k)n
We can also solve for EAC using a financial calculator as follows:

Number of Discount PV of
Enter Years Rate Costs 0
N I/Y PV PMT FV
Solve for EAC
Step 1. C alculate the present value of the annual operating costs for the equipment over one
life cycle of the project and add this sum to the initial cost of the equipment.
Step 2. Divide the present value of the costs (calculated in step 1) by the annuity present
value interest factor (note the abbreviated formula for this present value interest fac-
tor found in Equation (11–2)). You can think of the numerator of Equation (11–2) as
an amount of money that you might borrow to purchase a new car and the EAC as
your annual car payment.
2
This is the same formulation for the annuity present value interest factor used in Chapter 5, where the numerator has
been divided by the denominator (k).
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Checkpoint 11.2
Calculating the Equivalent Annual Cost

Suppose your bottling plant needs a new bottle capper. You are considering two different capping machines that will
perform equally well but that have different expected lives. The more expensive one costs $30,000 to buy, requires a
payment of $3,000 per year for maintenance and operation expenses, and will last for five years. The cheaper model
costs only $22,000, requires operating and maintenance costs of $4,000 per year, and lasts for only three years.
Regardless of which machine you select, you intend to replace it at the end of its life with an identical machine with
identical costs and operating performance characteristics. Because there is not a market for used cappers, there
will be no salvage value associated with either machine. Let’s also assume that the discount rate on both of these
machines is 8 percent.

You are considering two alternative pieces of equipment, one with a five-year life and one with a three-year life:
Project Long (Five-Year Life):

k = 8%
Cash Flow –$30,000 –$3,000 –$3,000 –$3,000 –$3,000 –$3,000
Project Short (Three-Year Life):

k = 8%
Time Period 0 1 2 3 Years
Cash Flow –$22,000 –$4,000 –$4,000 –$4,000

The question we need to answer is which capping machine offers the lowest cost per year of operation. We can
use a calculator to determine the EAC for each piece of equipment, which will tell us the cost per year for each
alternative, and then choose the one with the lower cost.
STEP 3: Solve
Using the Mathematical Formulas. The present value of the costs of the five-year project can
be calculated using a slightly modified version of Equation (11–1) (solving for PV of costs instead of NPV) as follows:
CF1 CF2 CF3 CF4 CF5
PV of Costs = CF0 + 1
+ + + 4
+
(1 + k) (1 + k) 2
(1 + k) 3
(1 + k) (1 + k)5
-$3,000 -$3,000 -$3,000 -$3,000 -$3,000
= -$30,000 + + + + +
(1 + .08)1 (1 + .08)2 (1 + .08)3 (1 + .08)4 (1 + .08)5
= -$41,978
Similarly, for the three-year project we calculate the present value of the costs as follows:
CF1 CF2 CF3
PV of Costs = CF0 + 1
+ 2
+
(1 + k)(1 + k) (1 + k)3
-$4,000 -$4,000 -$4,000
= -$22,000 + 1
+ 2
+
(1 + .08) (1 + .08) (1 + .08)3
= -$32,308
Now that we have the present values of the projects’ costs, we can compute the EAC for each, which is the
annual cash flow that is equivalent to the present value of the costs. For the five-year project, the EAC is
PV of Costs -$41,978
EACLong project = = = - $10,514
Annuity Present Value 1 1
a1 - b
Interest Factor .08 (1+ .08)5
M11_TITM2189_13_GE_C11.indd 370 18/05/17 12:47 PM

The three-year project’s EAC can be computed in the same way:

PV of Costs -$32,308
EACShort project = = = - $12,537
Annuity Present Value 1 1
a1 - b
Interest Factor .08 (1+ .08)3
We are not going to go through the steps used to solve for EAC here because a financial calculator can be used
to solve the problem quite easily.
Using a Financial Calculator. First, after clearing your calculator, calculate the present value of
the cost for one life cycle of each project.
Project Long:

CF; -30,000; ENTER CF0 = -30,000.00
T ; -3,000; ENTER C01 = -3,000.00
T ; 5; ENTER F01 = 5.00
NPV; 8; ENTER I = 8
T CPT NPV = -41,978
Project Short:

CF; −22,000; ENTER CF0 = -22,000.00
T ; −4,000; ENTER C01 = -2,000.00
T ; 3; ENTER F01 = 3.00
NPV; 8; ENTER I = 8
T CPT NPV = -32,308
Note that the present values of the costs of both pieces of equipment are negative because we are calculating
the present values of the costs.
Second, we calculate the values of the annuity payments over the project’s life that would produce the
same present values of the costs that you just calculated.
Project Long:
Enter 5 8.0 -41,978 0
N I/Y PV PMT FV
Solve for 10,514
EACLong project = -$10,514

Project Short:
Enter 3 8.0 -32,308 0
N I/Y PV PMT FV
Solve for 12,537
EACShotr project = -$12,537

STEP 4: Analyze
We can see that the EAC associated with the longer-lived machine, −$10,514, is less than the EAC for the shorter-
lived machine, −$12,537; thus, we should purchase the longer-lived machine. In effect, it is the less-expensive
alternative even though it costs more to purchase originally. The reason this works out is that by spending the extra
money required to buy the longer-lived machine, we do not have to repeat the purchase for five years; in contrast,
the shorter-lived machine, although cheaper to purchase, must be replaced every three years. This is not always
the case, however, as it depends on the cost of acquiring the longer-lived machine and the annual operating costs.
(11.2 CONTINUED >> ON NEXT PAGE)
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The EAC decision criterion is generally applied to mutually exclusive projects where the only difference is in
the length of life and the costs. Thus, with the EAC we ignore cash inflows because they are identical. However,
if the mutually exclusive projects produce different cash inflows, we can still use this technique, but rather than
calculating the present value of each project’s costs (which would have a negative value), we calculate each
project’s NPV (which should have a positive value) and select the project with the highest EAC.

What is the EAC for a machine that costs $50,000, requires an annual payment of $6,000 for maintenance and
operation, and lasts for six years? You may assume that the discount rate is 9 percent and that there will be no
salvage value associated with the machine. In addition, you intend to replace this machine at the end of its life
with an identical machine with identical costs.
ANSWER: EAC = -$17,146.

Your Turn: For more practice, do related Study Problem 11–4 at the end of this chapter. >> END Checkpoint 11.2
Tools of Financial Analysis—Equivalent Annual Cost (or Equivalent Annual Annuity)

Equivalent annual PV of All Cash Flows • An estimate of the annualized present value
cost (EAC) or EAC = of a project’s cash flows.
Annuity Present Value
equivalent annual Interest Factor • Where all project cash flows are negative,
annuity (EAA) then the lower the EAC is, the less costly
CF1 CF2 CFn
CF0 + + + g + the project is to operate per year.
11 + k2 1 11 + k2 2 11 + k2 n • For a normal project with positive future
=
1 1 cash flows, the EAC is the annualized NPV
a - b of the project. This metric is sometimes
k k11 + k2 n
used to compare projects that have different
NPV initial costs and different useful lives.
=
1 1
a - b
k k11 + k2 n

1. Describe what the NPV tells the analyst about a new investment opportunity.
2. What is the equivalent annual cost (EAC) measure, and when should it be used?
3. What is capital rationing?
11.3 Other Investment Criteria

Although the NPV investment criterion makes the most sense in theory, in practice financial
managers use a number of criteria to evaluate investment opportunities. Criteria that we
explore in this section include the profitability index, internal rate of return, modified internal
rate of return, and payback period.
Profitability Index
The profitability index (PI) is a cost-benefit ratio equal to the present value of an invest-
ment’s future cash flows divided by its initial cost:3
Profitability Present Value of Initial Cash
= a b , a b
Index 1PI2 Future Cash Flows Outlay
3
While the initial outlay is a negative value because it is an outflow, we do not give it a negative sign in calculating the PI.
Instead, the initial outlay is entered as a positive value, since we are interested only in the ratio of benefits to costs.
M11_TITM2189_13_GE_C11.indd 372 18/05/17 12:47 PM

or
Cash Flow Cash Flow Cash Flow
for Year 1 1CF1 2 for Year 2 1CF2 2 for Year n 1CFn 2
+ + g +
Discount 1 Discount 2 Discount n (11–3)
a1 + b a1 + b a1 + b
Profitability Rate 1k2 Rate 1k2 Rate 1k2
=
Index 1PI2 Initial Cash Outlay 1-CF0 2
A PI greater than 1 indicates that the present value of the investment’s future cash flows ex-
ceeds the cost of making the investment, so the investment should be accepted. For the condo
investment we discussed in the introduction, the PI is equal to 1.087 = $100,000/$92,000.
Note that when computing the PI, we use a positive value for the initial cash outlay (CF0).
This is done so that the PI is a positive ratio. Technically, because the initial outlay for most
investments is a cash outflow, the sign on this number is negative.
The PI is closely related to the NPV because it uses the same inputs: the present value of
the project’s future cash flows and the initial cash outlay. The PI is a ratio of these two quanti-
ties, and the NPV is the difference between them:
Profitability Present Value of Initial Cash
= ,
Index 1PI2 Future Cash Flows Outlay
and
Net Present Present Value of Initial Cash
= -
Value (NPV) Future Cash Flows Outlay
NPV Decision Criterion: When the PI is greater than 1, the NPV will be positive, so
the project should be accepted. When the PI is less than 1, the NPV will be negative,
which indicates a bad investment, so the project should be rejected.
The PI of an investment is always greater than 1 for all positive-NPV projects and is always
less than 1 for all negative-NPV projects. Thus, for independent projects, the NPV criterion and the
PI criterion are exactly the same. However, for mutually exclusive projects that have different costs,
the criteria may provide different rankings. For example, suppose that Project 1 costs $200,000 and
has future cash flows with a present value of $250,000 and that Project 2 costs $500,000 and has
future cash flows with a present value of $600,000. Project 2 has the higher NPV: $100,000 versus
$50,000 for Project 1. But Project 1 has the higher PI: 1.25 versus 1.20 for Project 2.
Firms with easy access to capital prefer the NPV criterion because it measures the
amount of wealth created by the investment. However, if the firm’s management have a
limited amount of capital and cannot undertake all of its positive-NPV investments, the PI
offers a useful way to rank investment opportunities to determine which ones to accept.
The PI is useful in this setting because, unlike the NPV, it measures the amount of wealth
created per dollar invested.
Tools of Financial Analysis— Profitability Index

Profitability index Present Value of • Sometimes referred to as the
(PI) Future Cash Flows cost-benefit ratio, the PI is a rela-
PI = = tive valuation measure.
Initial Cash
• A PI ratio greater than 1 indicates
Outlay 1CF0 2 that the project’s cash flows are
Cash Flow Cash Flow Cash Flow more valuable than the cost of
for Year 1 1CF1 2 for Year 2 1CF2 2 for Year n 1CFn 2 making the investment.
+ + g + • If the PI is greater than 1, then
Discount 1 Discount 2 Discount n
a1 + b a1 + b a1 + b the NPV is greater than 0, so the
Rate 1k2 Rate 1k2 Rate 1k2 NPV and the PI provide the same
Initial Cash signal as to whether a project
Outlay 1CF0 2 creates shareholder value.
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Internal Rate of Return

The internal rate of return (IRR) of an investment is analogous to the yield to maturity (YTM)
on a bond, which we defined in Chapter 9. Specifically, the IRR is the discount rate that results in
a zero NPV for the project. For example, if you invest $100 today in a project expected to return
$120 in one year, the IRR for the investment is 20 percent. We can show that this is correct by
discounting the $120 cash flow one year at 20 percent, which results in a present value equal to
the initial cash outlay of $100 (CF0 = -100). The result, then, is an NPV of zero.
Cash Flow
Net Present Cash Flow for Year 1 1CF1 2
= + = 0
Value for Year 0 1CF0 2 Internal Rate 1
a1 + b
of Return 1IRR2
$120
0 = -$100 +
11 + IRR2
Checkpoint 11.3
Calculating the Profitability Index for Project Long

Project Long is expected to provide five years of cash inflows and to require an initial investment of $100,000. The dis-
count rate that is appropriate for calculating the PI of Project Long is 17 percent. Is Project Long a good investment op-
portunity? (See Checkpoint 11.1 for cash flow details.)

the next five years.
k=?
Cash Flow –$100,000 $70,000 $30,000 $30,000 $25,000 $10,000

The PI for Project Long is equal to the present value of the project’s expected cash flows for Years 1 through 5
divided by the negative value of the initial cash outlay (–CF0). Thus, the first step in the solution is to calculate the
present value of the future cash flows, discounting those cash flows using k = 17%. We then divide this quantity
by $100,000. Note that although the initial cash outlay is a negative number, we make it positive when we divide
so that the PI comes out positive.
STEP 3: Solve
In Checkpoint 11.1, we demonstrated how to calculate the present value of Project Long’s future cash flows
using the time-value-of-money formulas, a financial calculator, and a spreadsheet. Thus, we only summarize the
results of these calculations below:
k = 17%
Cash Flow $(100,000) $70,000 $30,000 $30,000 $25,000 $10,000
$ 59,829
$ 21,915
The present value of the
expected cash flows for Years $ 18,731
1 through 5 is $118,378.
$ 13,341
$ 4,561
Present value of cash flows for Years 1 – 5 = $ 118,378
Less: Initial cash outlay = $(100,000)
Equals: Net present value = $ 18,378
Profitability index = $118,378/100,000 = 1.18378
M11_TITM2189_13_GE_C11.indd 374 18/05/17 12:47 PM

STEP 4: Analyze
Project Long requires an initial investment of $100,000 and provides future cash flows that have a present value
of $118,378. Consequently, the project’s future cash flows are worth 1.18378 times the initial investment. Be-
cause the project’s future cash flows are worth more than the initial cash outlay required to create the investment,
this is an acceptable project.

PNG Pharmaceuticals, Inc., is considering an investment in a new automated materials handling system that is
expected to reduce its drug manufacturing costs by eliminating much of the waste currently involved in its spe-
cialty drug division. The new system will require an initial investment of $50,000 and is expected to provide cash
savings over the next six-year period as follows:
Year Expected Cash Flow

Initial outlay (Year 0) $(50,000)
Year 1 15,000
Year 2 8,000
Year 3 10,000
Year 4 12,000
Year 5 14,000
Year 6 16,000
PNG uses a 10 percent discount rate to evaluate investments of this type. Should PNG go forward with the
investment? Use the PI to evaluate the project.
ANSWER: PI = 1.0733.
Your Turn: For more practice, do related Study Problem 11–26 at the end of this chapter. >> END Checkpoint 11.3
For investments that offer more than one year of expected cash flows, the calculation
is a bit more tedious. Mathematically, we solve for the internal rate of return for a multiple-
period investment by solving for IRR, which is the unknown discount rate in the following
equation that makes the present value of the investment cash flows (the initial outlay and
future cash flows) equal to zero. In other words, using the IRR as the discount rate makes
the NPV equal to zero:
Cash Flow Cash Flow

Net Present Cash Flow for Year 1 1CF1 2 for Year 2 1CF2 2
= + +
Value for Year 0 1CF0 2 Internal Rate 1 Internal Rate 2
a1 + b a1 + b
of Return 1IRR2 of Return 1IRR2
Cash Flow
for Year n 1CFn 2
+ g + = 0 (11–4)
Internal Rate n
a1 + b
of Return 1IRR2
Solving for IRR when there are multiple future periods can be done in several ways, which we
demonstrate in Checkpoint 11.4.
IRR Decision Criterion: Accept the project if the IRR is greater than the required rate of return or
discount rate used to calculate the net present value of the project, and reject it otherwise.
M11_TITM2189_13_GE_C11.indd 375 18/05/17 12:47 PM

Checkpoint 11.4
Calculating the Internal Rate of Return

for Project Long
Project Long is expected to provide five years of cash inflows and to require an initial investment of $100,000. The required
rate of return or discount rate that is appropriate for valuing the cash flows of Project Long is 17 percent. What is Project
Long’s IRR, and is it a good investment opportunity?

the next five years.
k = 17%
Cash Flow –$100,000 $70,000 $30,000 $30,000 $25,000 $10,000

With projects that provide multiple cash flows received over many years, calculating a single rate of return re-
quires that we estimate the project’s IRR. Specifically, the IRR for Project Long is the discount rate that makes the
present value of Project Long’s future cash flows equal, in absolute terms, to the initial cash outflow of $100,000.
We could solve for this discount rate by trial and error—that is, by experimenting with different discount rates
to find the one that satisfies our definition of NPV. However, as we demonstrate here, this can be very time-
consuming. Luckily, we can use either a financial calculator or a spreadsheet program such as Microsoft Excel
to solve for the IRR. We illustrate both of these methods here.
STEP 3: Solve
Before we demonstrate the solution methods, let’s first take a look at the solution, which we will find to be 27.68
percent. Discounting the project cash flows for Years 1 through 5 back to the present using the IRR, which is
27.68 percent, we see that the resulting NPV is 0.
k = 27.68%
Cash Flow $(100,000) $70,000 $30,000 $30,000 $25,000 $10,000
$ 54,826
$ 18,404
The present value of the expected cash
flows for Years 1 through 5 is $100,000 $ 14,414
when discounted using 27.68%.
$ 9,408
$ 2,948
Present value of cash flows for Years 1 – 5 = $ 100,000
Less: Initial cash outlay = $(100,000)
Net present value = $ 0
Using the Mathematical Formulas. To solve for the IRR by hand, we follow a trial-and-error
approach. Using this method, we must calculate the NPV using many different discount rates until we find the
discount rate that produces a zero NPV. For example, if we were to calculate the NPV for discount rates start-
ing with 0 percent and increasing in increments of 4 percent up to 68 percent, we would get the following set
of results (note that we have cheated here and used an Excel spreadsheet to reduce the tedium of making all
these NPV calculations).
M11_TITM2189_13_GE_C11.indd 376 18/05/17 12:47 PM

Discount Computed
Rate NPV
0% $ 65,000
4% $ 51,304 NPV profile for Project Long
8% $ 39,532
12% $ 29,331 $80,000
16% $ 20,428 $60,000 Note: Since the NPV = 0 for a
20% $ 12,603 discount rate between 24%
Net present value
24% $ 5,683 $40,000 and 28% the IRR is between

28% $ (473) 24% and 28%.
NPV = 0 32% $ (5,978) $20,000
36% $ (10,926)
40% $ (15,394) $0
44% $ (19,445) 0% 10% 20% 30% 40% 50% 60% 70% 80%
48% $ (23,133) $(20,000)
52% $ (26,504)
$(40,000)
56% $ (29,595)
60% $ (32,439) $(60,000)
64% $ (35,063) Discount rate
68% $ (37,492)
Notice that the computed NPV approaches a value of zero where we use a discount rate between 24 and 28
percent. This graph of NPVs and different discount rates is called the NPV profile of the project (we will have more
to say about this profile later). We can calculate the IRR directly using either a financial calculator or spreadsheet,
as we now demonstrate.
Using a Financial Calculator.

CF; –100,000; ENTER CF0 = -100,000.00
T ; 70,000; ENTER C01 = 70,000.00
T ; 1; ENTER F01 = 1.00
T ; 30,000; ENTER C02 = 30,000.00
T ; 2; ENTER F02 = 2.00
T ; 25,000; ENTER C03 = 25,000.00
T ; 1; ENTER F03 = 1.00
T ; 10,000; ENTER C04 = 10,000.00
T ; 1; ENTER F04 = 1.00

IRR; CPT IRR = 27.68%
Using an Excel Spreadsheet. Cell B10 contains the Excel formula for the IRR calculation, which
appears as = IRR (B3:B8). The only inputs to the IRR function in Excel are the project cash flows.4
A B
1 Annual
2 Year Cash Flows
3 0 $(100,000)
4 1 70,000
5 2 30,000
6 3 30,000
7 4 25,000
8 5 10,000 Entered equation in Cell B10: 5 IRR(B3:B8)
9
10 IRR 5 27.68%
What appears in the spreadsheet, then, is the IRR of 27.68 percent.

4
Actually, the IRR function will appear with a final input option for [guess], which allows you to enter a guess as to
what the IRR may be. However, this is typically not needed for Excel to calculate the IRR.
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STEP 4: Analyze
Project Long requires an initial investment of $100,000 and provides future cash flows that offer a return on this
investment of 27.68 percent. Because we have decided that the minimum rate of return we need to earn on this
investment is 17 percent, it appears that Project Long is an acceptable investment opportunity.

Knowledge Associates, a small consulting firm in Portland, Oregon, is considering the purchase of a new copying
center for the office that can copy, fax, and scan documents. The new machine costs $10,010 to purchase and is ex-
pected to provide cash flow savings over the next four years of $1,000, $3,000, $6,000, and $7,000. The employee
in charge of performing a financial analysis of the proposed investment has decided to use the IRR as her primary crite-
rion for making a recommendation to the managing partner of the firm. If the required rate of return or discount rate the
firm uses to value the cash flows from office equipment purchases is 15 percent, is this a good investment for the firm?
ANSWER: IRR = 19 percent.
Your Turn: For more practice, do related Study Problems 11–9, 11–12, 11–19, and 11–26 at the
end of this chapter. >> END Checkpoint 11.4
Complications with the IRR: Multiple Rates of Return

An investment project will always have only one NPV. However, in some situations an invest-
ment project can have more than one IRR. We can trace the reasons for this to the calculations
involved in determining the IRR. In Equation (11–4), we defined the IRR as the discount rate
that results in an NPV calculation of zero:
CF1 CF2 CF3 CFn
NPV = CF0 + + + + g+ = 0 (11–4)
11 + IRR2 1
11 + IRR2 2
11 + IRR2 3 11 + IRR2 n
When the first cash flow is negative (the initial investment) and the subsequent cash flows are
positive, there is one unique IRR. However, there can be multiple values for the IRR that solve
Equation (11–4) when at least one of the later cash flows is negative.5 Consider, for example,
the following project:
k=?
Time Period 0 1 2 Years
Cash Flow –$235,000 $540,500 –$310,200
In Checkpoint 11.5, we calculate the IRR for this project and find that both 10 and 20 percent
solve this problem.
Which solution (IRR) is correct? The answer is that neither solution is valid. Although
each fits the definition of the IRR, neither provides the true project returns. In summary, when
there is more than one sign reversal in the cash flow stream, the possibility of multiple IRRs
exists, and when there are multiple IRRs, we can no longer use this investment criterion to
evaluate the project. Fortunately, NPV is not subject to this problem.
Using the IRR with Mutually Exclusive Investments
IRRs are often used by managers to select among mutually exclusive investments. A compli-
cation can arise in this setting, since there often are ranking conflicts between the NPV and
the IRR of the evaluated projects. That is, although both mutually exclusive projects may have
positive NPVs and IRRs greater than their required rates of return, one project may have a
5
To be specific, there can be as many IRRs as there are changes in the sign of the cash flows over the n-year project life.
Technically, the multiple IRR problem arises out of the fact that the IRR we calculate is actually the solution to an nth de-
gree polynomial equation, where n is the number of years over which cash flows are produced by the project (and, conse-
quently, the highest exponent in the equation). The seventeenth-century philosopher René Descartes gave us Descartes’
Rule of Signs, which can be used to tell us the maximum number of IRRs that a given project can produce. Here’s how
it works: There can be a different IRR for each sign change in a project’s cash flows over its n-year life. For example,
Project Long only has one sign change: In Year 0, the project has a negative $100,000 cash outlay, followed in Year 1 by
a positive $70,000. The project can therefore have a maximum of one IRR. Note that the Rule of Signs says a project
can have a maximum number of IRRs equal to the number of sign changes, but the actual number of IRRs may be fewer.
M11_TITM2189_13_GE_C11.indd 378 18/05/17 12:47 PM

higher NPV, whereas the other has a higher IRR. When this is the case, which criterion should
we go with, the higher NPV or the higher IRR?
For example, Apex Engineering is considering the purchase of an automated accounting
system. Two software systems are being considered that will perform the same functions,
Automated Accounting Plus (AA + ) and Business Basics Reporting (BBR). The cash flows
from the AA + system grow over time because this system offers the user the opportunity to
expand functionality. The cash flows for the BBR system, on the other hand, decline over time
as the initial cost savings are captured in the early years of implementation. The expected cash
flows of the two systems are found in Panel A of Figure 11.1.
Note that both accounting systems provide positive NPVs using the firm’s 15 percent
discount rate or required rate of return. This suggests that one of the two systems should in-
deed be purchased. However, the AA + system, which offers an NPV of $412,730 compared
to $370,241 for the BBR alternative, has the lower IRR (38 percent compared to 52 percent).
Why do the two criteria provide different answers? It is because the larger cash flows come
earlier for the BBR system. The BBR system earns a very high return—but over a shorter
period of time. The fact that the BBR system uses the firm’s capital over a shorter time period
may be relevant if there are constraints on the firm’s ability to raise capital (that is, if capital
is being rationed). However, if the firm has unlimited access to external capital markets, the
project with the higher NPV should be chosen.
To examine this more closely, we will look at each project’s NPV profile, a graph of
its NPV using required rates of return ranging from 0 percent to 65 percent. As shown in
Panel B of Figure 11.1, for discount rates below 19.5 percent, the AA + system offers higher
NPVs, and for higher discount rates, the BBR system has higher NPVs. This implies that if
the appropriate required rate of return for the projects is less than 19.5 percent and the firm
is not capital-constrained, the AA + system should be taken. However, if the firm is capital-
constrained and is likely to have opportunities with IRRs greater than 19.5 percent in the near
future, it may want to take the BBR system, which allows it to recover its capital sooner.
Checkpoint 11.5
The Problem of Multiple Internal Rates

of Return for Projects
Descartes’ Rule of Signs tells us that there can be as many IRRs for an investment project as there are changes in the sign of
the cash flows over its n-year life. To illustrate the problem, consider a project that has three cash flows: a −$235,000 outlay
in Year 0, a $540,500 inflow in Year 1, and a –$310,200 outflow at the end of Year 2. Calculate the IRR for the investment.

k=?
Cash Flow –$235,000 $540,500 –$310,200

To solve the problem, we determine the discount rate that makes the NPV = 0 by constructing an NPV profile
for the project. In this instance, we use discount rates in increments of 2 percent ranging from 0 percent to 30
percent.
STEP 3: Solve
We calculate the discount rate that makes the investment’s NPV = 0 using discount rates ranging from 0 percent
to 30 percent. For example, the NPV for a 10 percent discount rate is calculated using Equation (11–1) as follows:
CF1 CF2
NPV = CF0 + 1
+ (11–1)
11 + k2 2
11 + k2
$540,500 -$310,200
= -$235,000 + 1
+ = 0
11 + .102 11 + .102 2
M11_TITM2189_13_GE_C11.indd 379 18/05/17 12:47 PM

Discount Net Present

Rate Value
0% $(4,700) $1,000
2% $(3,253)
4% $(2,086) 0
6% $(1,171)
Net present value
8% $ (484) 0% 5% 10% 15% 20% 25% 30% 35%

(1,000)
10% $ 0
12% $ 300 (2,000) IRR = 10% IRR = 20%
14% $ 434
16% $ 419 (3,000)
18% $ 270
20% $ 0 (4,000)
22% $ (379)
24% $ (856)
(5,000)
26% $(1,421) Required rate of return
28% $(2,065)
30% $(2,781)
STEP 4: Analyze
There are two IRRs for this project: 10 percent and 20 percent. This results from the fact that there are two sign
changes in the project cash flows. At this point we can turn to NPV to evaluate the investment opportunity or use
a modified version of IRR which is discussed in the next section.

Suppose that the firm considering the above investment is able to pay an additional $65,000 in Year 0, which
pays for cleanup expenses at the end of the project’s life in Year 3. In its previous analysis, the firm estimated
these costs to be $100,000, so the Year 3 cash outflow is reduced to $210,200. What is your estimate of the
firm’s NPV and IRR for the project based on the renegotiated cash flows?
ANSWER: The revised cash flows result in an NPV of $14,572 and an IRR of 23.07%. Moreover, a review of the NPV profile for the
project reveals that there is but one IRR.
>> END Checkpoint 11.5
Tools of Financial Analysis—Internal Rate of Return

Internal rate Present Value • The compound annual rate of return earned on an investment.
of return (IRR) ° of Future Cash Flows ¢ = 0 • An IRR greater than the required rate of return for the investment sig-
Discounted Using IRR nals a good investment.
• The IRR is analogous to the yield to maturity (YTM) on a bond defined
Note that the IRR is the discount rate in Chapter 9.
that makes the NPV equal to zero.
Modified Internal Rate of Return

As we discovered earlier, in cases where there is more than one IRR for a particular project,
the IRR criterion is less useful. In order to eliminate the problem of multiple IRRs, the modi-
fied internal rate of return (MIRR) was developed. The idea behind the MIRR is to rear-
range the project cash flows so that there is only one IRR. We do this by modifying the project
cash flows so there is just one change in the sign of the cash flows over the life of the project.
This can be accomplished by discounting all the negative cash flows after the initial cash
outflow back to Year 0 and adding them to the initial cash outflow. This process is described
as follows:
STEP 1. M
odify the project cash flow stream by discounting the negative future cash
flows back to the present using the required rate of return (that is, the dis-
count rate that is used to calculate the project’s NPV). The present value of
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Figure 11.1
Ranking Mutually Exclusive Investments: NPV Versus IRR
Apex Engineering is considering the purchase of an automated accounting system and is trying to decide between the AA + and BBR sys-
tems. Both systems have the same cost, but because of functionality differences, the patterns of cash flows are quite different. Apex uses a
15 percent required rate of return or discount rate to evaluate its investments.
(Panel A) Expected Cash Flows

• Both alternatives have positive NPVs and IRRs that
exceed Apex’s 15% required rate of return.
Year AA BBR
• However, the projects are ranked differently using NPV
0 $(500,000) $(500,000) or IRR: AA has the higher NPV, while BBR has a higher
IRR.
1 100,000 400,000
• The ranking difference is due to the effect of discounting
2 200,000 300,000 and the difference in the patterns of the cash flows for
the two projects.
3 300,000 200,000
• AA ’s cash flows increase over time, while BBR’s
4 400,000 200,000 decrease.
5 500,000 100,000 • Higher discount rates have a disproportionate effect on
present values, as we see in Panel B.
NPV $412,730 $370,241
IRR 38% 52%
(Panel B) NPV Profiles

$1,200,000
Discount Rate AA BBR $1,000,000

0% $1,000,000 $700,000 AA+
$800,000 NPVs are equal
5% $ 756,639 $568,722 for a discount rate
of about 20%.
Computed NPV
$600,000
10% $ 565,259 $460,528
15% $ 412,730 $370,241 $400,000 IRR for AA+ IRR for BBR
BBR = 38% = 52%
20% $ 289,673 $294,046 $200,000
25% $ 189,280 $229,088
$0
30% $ 106,532 $173,199 0% 10% 20% 30% 40% 50% 60% 70%
$(200,000)
35% $ 37,680 $124,709
40% $ (20,111) $ 82,317 $(400,000)
Discount rate
45% $ (69,011) $ 44,998
50% $ (110,700) $ 11,934
55% $ (146,489) $ (17,531)
60% $ (177,414) $ (43,930)
65% $ (204,298) $ (67,701)
(Panel C) Estimating the Break-Even Discount Rate

Cash Flows Differential • Using a 19.5% discount rate, the two projects have
Cash Flows exactly the same NPV.
Year AA BBR BBR AA • For discount rates lower than this break-even
0 $(500,000) $(500,000) $ 0 19.5% rate, AA has the higher NPV, whereas for
higher discount rates BBR has the higher NPV.
1 100,000 400,000 $ 300,000
• Trust NPV. Given the discount rate appropriate for
2 200,000 300,000 $ 100,000 valuing project cash flows, NPV gives the correct
3 300,000 200,000 $(100,000) ranking of projects!
4 400,000 200,000 $(200,000)
5 500,000 100,000 $(400,000)
IRR of the Differential Cash Flows 19.5%
>> END FIGURE 11.1
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these future negative cash flows is then added to the initial outlay to form a modi-
fied project cash flow stream in which all the cash outflows have been moved
back to Year 0.
STEP 2. Calculate the MIRR as the IRR of the modified cash flow stream. We add the
“modified” to IRR because the MIRR is based on a modified set of cash flows.
Let’s reconsider Checkpoint 11.5, where there were two sign changes. Checkpoint 11.6
illustrates how we can eliminate the sign changes by discounting the negative cash flow in
Year 2 back to the present and combining it with the Year 0 initial cash outlay. The IRR of
the modified cash flows, or MIRR, of 12.07 percent exceeds the 12 percent required rate
of return or discount rate used to value the project cash flows, which indicates the project
is a good one.
To close our discussion of the MIRR, here are some summary points and caveats con-
cerning its use:
• There is more than one way to compute the MIRR, and each method can potentially
result in a different value for the MIRR. In our example, we discounted the project’s
negative cash flows back to the present using the project’s required rate of return and
then computed the MIRR from the modified cash flows. An alternative is to discount the
negative future cash flows to the present using the risk-free rate, which has the effect of
increasing the present value of the negative cash flows and thus lowering the IRR of the
entire cash flow stream. Some analysts prefer this approach because it reduces the level
of the MIRR and thereby provides a more conservative criterion when the cost of capital
is high and the cash flows are very uncertain.
• The NPV is our capital-budgeting method of choice. Unlike the IRR criterion, the
NPV approach is always straightforward and provides an estimate of the dollar
value created by investing in the project. This is true whether or not a unique estimate
of the IRR can be calculated.
Checkpoint 11.6
Calculating the Modified Internal Rate of Return

Reconsider the investment project in Checkpoint 11.5. The project we analyzed has three cash flows: a −$235,000 outlay
in Year 0, a $540,500 cash inflow in Year 1, and a –$310,200 outflow at the end of Year 2. Our analysis in Checkpoint
11.5 indicated that this investment has two IRRs, 10 percent and 20 percent. One way to reduce the number of IRRs to
only one is to use the MIRR method. We can do this in this example by moving the final negative cash flow to the present
by discounting it at 12 percent, which is the required rate of return for the project.
k = 12%
Cash Flow -$235,000 $540,500 -$310,200
First sign Second sign

change change
(- to +) (+ to -)

There are two sign changes in this cash flow stream. To implement the MIRR method, we can discount the Year
2 negative cash flow back to Year 0 using the 12 percent discount rate used to calculate the NPV and then
calculate the MIRR of the resulting cash flows for Years 0 and 1.
M11_TITM2189_13_GE_C11.indd 382 18/05/17 12:47 PM

STEP 3: Solve
Discount the Year 2 negative cash flow back to Year 0 and add it to the Year 0 initial cash outlay, which produces
a modified initial cash outflow for Year 0 of –$482,290 (–$235,000 – $247,290):
k = 12%
Cash Flow -$235,000 $540,500 -$310,200
Modified
-$247,290
initial cash
outflow -$482,290
The modified cash flows of the investment are as follows:

k = 12%
Cash Flow -$482,290 $540,500 $0
Calculating the IRR for these modified cash flows produces the MIRR of 12.07 percent.
STEP 4: Analyze
By eliminating the second sign change that occurs between Year 1’s positive cash flow and Year 2’s negative
cash flow, the computation of an IRR using the modified cash flow stream yields a single IRR that we refer to
as the MIRR. The MIRR is not the same as the IRR because it is based on modified cash flows that have been
moved around in time using the discount rate used to both value project cash flows and calculate the NPV (which
is not used in the IRR). Consequently, although the MIRR does produce a single rate-of-return estimate for the
project, it depends on the discount rate used to move the cash flows from period to period and is no longer
intrinsic to the project. For example, if the required rate of return had been 14 percent in this example, the MIRR
would have been 14.10 percent (not 12.07 percent). The NPV, on the other hand, does not suffer from the
multiple IRR problem and yields consistent results even in the face of multiple sign changes.

Assume the required rate of return used to discount the cash flows in this example is changed to 8 percent.
What is the MIRR?
ANSWER: Using the 8 percent discount rate results in a MIRR of 7.90 percent. Note that the project has a negative NPV of
−$483.54 for this lower required rate of return. Can you explain why the NPV goes negative when the discount rate is lowered? (Hint:
Reducing the discount rate from 12 percent to 8 percent makes the present value of the negative cash flow in Year 2 much larger.)
Your Turn: For more practice, do related Study Problems 11–14, 11–17, and at the end of this chapter. >> END Checkpoint 11.6
Tools of Financial Analysis—Modified Internal Rate of Return

Modified internal Present Value Present Value • The compound annual rate of
rate of return ° of Negative Cash Flows ¢ + ° of Positive Cash Flows ¢ = 0 return earned on the “modified”
(MIRR) cash flows for a project where
Discounted Using Cost of Capital Discounted Using MIRR cash flows have been modified to
This formula is solved using the following two steps: eliminate the possibility of get-
ting more than one IRR.
STEP 1. Modify the project cash flow stream by discounting the negative • Project cash flows are modified
future cash flows back to the present using the required rate of by discounting all the negative
return (that is, the discount rate that is used to calculate the proj- cash flows back to Year 0 using
ect’s NPV). the project’s discount rate and
STEP 2. Calculate the MIRR as the IRR of the modified cash flow stream. then adding them to the initial
cash outflow before computing
the IRR of the modified cash
flows or MIRR.
M11_TITM2189_13_GE_C11.indd 383 18/05/17 12:47 PM

$100,000
$90,000
$80,000
$70,000
$60,000
$50,000
$40,000
$30,000
$20,000
Finance for Life $10,000

$0
Professional
degree
Bachelor’s
degree
High school
diploma
No diploma
Higher Education as an Investment

in Yourself Average Earnings by Education Level, 2012
Source: U.S. Department of Labor, Bureau of Labor Statistics, Employ-
Your decision to pursue a college education, and specifically a busi- ment Projection (2012).
ness degree, can be viewed as an investment decision. After all, to
We do not have to do a lot of calculations to figure out that
go to college you must delay entering the workforce for four to six
education pays. For example, the average earnings differential of
years (or sometimes longer), and you are likely to spend between
$21,530 between the holder of a bachelor’s degree and that of a
$10,000 and $40,000 per year, depending on whether you attend a
high school diploma ($55,432 – $33,902), spread over a 45-year
public or private college or university.* Financially speaking, is it worth
working life and discounted using a 5 percent discount rate, pro-
it? We should hasten to point out that having a college education
duces a present value at the end of college of $382,676 and has
can (and should) enrich your life in ways that are not reflected in the
a present value of $314,828 today (assuming you are in college for
amount of money you earn. However, for our purposes, let’s concen-
four years). If the present value of the benefits of a college education
trate on the financial implications of getting a college degree.
is $314,828, what does it cost? Assuming that the cost of attend-
According to the U.S. Department of Labor’s Bureau of Labor
ing college is $15,000 for a public college and $35,000 for a pri-
Statistics, in 2012 the average annual earnings for workers ranged
vate college, the present values of the costs of attending college are
from only $24,492 per year for workers with no high school diploma
($53,189) and ($124,108), respectively. There’s one more important
to $90,120 for those with professional degrees. Simply having a
cost of attending college that we must consider, and that’s lost earn-
high school diploma increased earnings by over $9,000 a year, and
ings while in college. If we assume that the student would be earning
a bachelor’s degree almost doubled earnings for high school grads.
$20,000 per year for all four years he or she was not in college (this
The salaries reported in the diagram above are for all degrees
is approximately the minimum wage), the present value of four years
and across the complete spectrum of years of experience (new
of lost income is ($70,919). Adding up the costs of college (tuition
hires to those close to retirement). What about business degrees
and lost income), the present value cost of a public college degree is
and starting salaries in particular? For undergraduate business
$124,108 while that of a private college degree is $195,027. Com-
majors in the class of 2012, the average starting salary was
paring these costs with the present value of future benefits yields an
$53,900. This would suggest that down the road, after some
NPV of $190,720 for obtaining a bachelor’s degree from a public col-
experience, having a business degree would produce much
lege. Similarly, the NPV is $119,801 for obtaining a bachelor’s degree
higher average earnings than the $53,900 reported starting salary
from a private college.
for all majors.
Your Turn: See Study Question 11–11.
*This is the average cost of attending a public four-year college. The average cost of attending a private college was $35,074 in 2012–2013.
Source: http://nces.ed.gov/fastfacts/display.asp?id = 76, accessed February 11, 2016.
Payback Period
The payback period for an investment opportunity is the number of years needed to recover
the initial cash outlay required to make the investment. For example, suppose Exec Corpora-
tion was deciding whether to spend $8 million for a new software system that would allow it
to monitor the daily production from its thousands of operating oil and gas wells. If the new
automated system was to reduce the costs of monitoring production by $4 million a year, the
payback period for the investment would be only two years. Similarly, if the savings were
only $2 million per year, the payback period would be four years. If the savings were not the
M11_TITM2189_13_GE_C11.indd 384 18/05/17 12:47 PM

same each year, the company would simply cumulate them over time until they reached the
total investment outlay of $8 million. In this case, the payback period is often not an even
number of years. For example, if the savings for the first three years of the investment were $4
million, $3 million, and $2 million, the payback period would equal 2.5 years. The company
would recover $7 million of the investment during the first two years and the remaining $1
million from half of the third year’s savings—thus, a 2.5-year payback.
Payback Period Decision Criterion: Accept the project if the payback period is less than a
prespecified maximum number of years.
The payback criterion measures how quickly the project will return its original invest-
ment, which is a very useful piece of information to have when evaluating a risky investment.
Specifically, the longer the firm has to wait to recover its investment, the more things that can
happen that might reduce or eliminate the benefits of making the investment. However, using
the payback period as the sole criterion for evaluating whether to undertake an investment has
three fundamental limitations:
Limitation 1. The payback period calculation ignores the time value of money, treating, for
example, cash flows three years from now the same as cash flows in one year.
Limitation 2. The payback period method ignores cash flows that are generated by the
project beyond the end of the payback period.
Limitation 3. There is no clear-cut way to define the cutoff criterion for the payback
period that is tied to the value-creation potential of the investment.
To illustrate these limitations of the payback period method, consider the cash flows for
Project Long and Project Short found in Table 11.1. Both projects require an initial cash out-
lay of $100,000, and we assume that the payback criterion being used to evaluate the projects
is three years. Note that although both projects have the same payback period of two years,
which is shorter than the cutoff criteria of three years, we would clearly prefer Project Long
to Project Short for the following reasons:
1. Regardless of what happens after the payback period, Project Long returns the initial
investment earlier within the payback period (i.e., $70,000 in Year 1 as compared to only
$50,000 for Project Short).
2. Project Long generates $65,000 in cash flows during Years 3 through 5, whereas Project
Short provides no cash flows after the payback period.
Discounted Payback Period

To deal with the criticism that the payback period method ignores the time value of money,
some firms use the discounted payback period approach. The discounted payback period
approach is similar to that of the traditional payback period except that it uses discounted cash
flows (using the same discount rate used in calculating the NPV) to calculate the payback pe-
riod. Thus, the discounted payback period is defined as the number of years needed to recover
the initial cash outlay from the discounted cash flows.
Discounted Payback Period Decision Criterion: Accept the project if its discounted
payback period is less than the prespecified number of years.
If we assume that the discount rate for Projects Long and Short is 17 percent, the dis-
counted cash flows calculated for these projects are as shown in Table 11.2. After two years,
Project Long still needs $18,256 in present value dollars to achieve payback. Therefore, pay-
back occurs when approximately 97 percent of Year 3’s discounted cash flow is received (i.e.,
$18,256/$18,731). Thus, Project Long has a discounted payback period of 2.97 years. Project
Short, on the other hand, never achieves discounted payback, as the cumulative present value
of its cash flows falls $20,739 short of the initial investment at the end of its life in Year 2.
Clearly, the discounted payback period method is an improvement over the straight payback
period method.
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Table 11.1 Limitations of the Payback Period Criterion
Limitations of the payback period as an investment criteria include the following:

a. Does not account for the time value of money
b. Does not consider cash flows beyond the payback period
c. Utilizes an arbitrary cutoff criterion
Project Long Project Short

The payback period equals Annual Cash Cumulative Annual Cash Cumulative Cash
two years for both projects Flow Cash Flow Flow Flow
because it takes two years to
recover the cost of the initial Initial cash outlay $(100,000) $(100,000) $(100,000) $(100,000)
outlay from the cash inflows. Year 1 70,000 (30,000) 50,000 (50,000)
However, Project Long looks a
lot better because it continues Year 2 30,000 0 50,000 0
to provide cash inflows after the Year 3 30,000 30,000 0 0
payback year.
Year 4 25,000 55,000 0 0
Year 5 10,000 65,000 0 0
Table 11.2 Discounted Payback Period Example (discount rate = 17%)
The standard payback period method does not account for the time value of money; the dis-
counted payback period method discounts investment cash flows back to the present before cu-
mulating them to calculate payback.
Project Long
Cumulative
Annual Cash Cumulative Discounted Discounted
The discounted payback Flow Cash Flow Cash Flow Cash Flow
period equals 2.97 years for
Project Long. Three years of Initial cash outlay $(100,000) $(100,000) $(100,000) $(100,000)
discounted cash flows sum
to a positive $476. However,
Year 1 70,000 (30,000) 59,829 (40,171)
since we need to sum to 0, we Year 2 30,000 0 21,915 (18,256)
do not need a full three years
Year 3 30,000 30,000 18,731 476
of discounted cash flows (we
need $18,256/$18,731 = .97 Year 4 25,000 55,000 13,341 13,817
of Year 3’s cash inflow). Year 5 10,000 65,000 4,561 18,378
Project Short
Cumulative
Annual Cash Cumulative Discounted Discounted
Flow Cash Flow Cash Flow Cash Flow
Discounted payback is never Initial cash outlay $(100,000) $(100,000) $(100,000) $(100,000)
achieved for Project Short. The Year 1 50,000 (50,000) 42,735 (57,265)
discounted cash flows never
cumulate to equal zero. Year 2 50,000 0 36,526 (20,739)
Year 3 – – – (20,739)
Year 4 – – – (20,739)
Year 5 – – – (20,739)
Although the deficiencies of the payback criterion do limit the usefulness of the payback
period and discounted payback period methods as tools for investment evaluation, these meth-
ods have several positive features as supplemental tools for evaluating investment opportuni-
ties in conjunction with net present value:
1. For many individuals, both the payback and the discounted payback period methods are
more intuitive and easier to understand than other decision criteria such as NPV.
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2. The payback period is often used as a crude indicator of project risk because payback
favors projects that produce significant cash flows in the early years of a project’s life,
which, in general, are less risky than more distant cash flows.
3. The discounted payback period method is used as a supplemental analytical tool in
instances where obsolescence is a risk; the method provides insights about whether a
company will get its money back in today’s dollars before the market disappears or the
product is obsolete.
4. Managers often find the payback period method useful when capital is being rationed;
the method provides insights about how long the company’s capital will be tied up in the
project.
Tools of Financial Analysis—Payback Measures
Payback period The number of years of • The number of years needed to recover the
project cash flows that are initial cash outlay for the investment.
required to recover the ini- • Project cash flows are summed but not dis-
tial cash investment in the counted to determine the payback period.
project. • There is no hard-and-fast rule for determin-
ing the minimum payback period, however.
Discounted The number of years of dis- • The discounted payback period method
payback period counted project cash flows sums the present value of future cash flows
that are required to recover to determine payback.
the initial cash investment in • There is no hard-and-fast rule for determin-
the project. Future cash flows ing the minimum discounted payback pe-
are discounted using the cost riod, however.
of capital for the investment.
Summing Up the Alternative Decision Rules

We have reviewed six different decision rules that are used by businesses to evaluate new
investment alternatives. The NPV decision rule, which considers the expected impact of an
investment alternative on shareholder value, is generally the preferred rule for making invest-
ment decisions. However, as we have discussed, there are a number of other techniques that
enjoy widespread use. Table 11.3 summarizes each of these methods, providing a definition of
each method, a description of its investment decision rule, and some brief comments concern-
ing the pros and cons of the methodology.

1. Describe what the IRR metric tells the analyst about a new investment opportunity.
2. Describe the situations in which the NPV and IRR metrics can provide conflicting signals.
3. What is the modified internal rate of return metric, and why is it sometimes used?
4. What is the payback period method, and what is the source of its appeal?
5. What is the discounted payback period method, and how does it improve on the payback period measure?
11.4 A Glance at Actual Capital-Budgeting

Practices
During the past 50 years, the popularity of each of the capital-budgeting methods we have
discussed here has shifted rather dramatically. In the 1950s and 1960s, the payback period
method dominated all other capital-budgeting metrics; however, in recent years the internal
rate of return and the net present value techniques have gained in popularity and today are
used by virtually all major corporations.
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Table 11.3 Basic Capital-Budgeting Techniques
These are the primary capital-budgeting techniques or criteria that are used in industry practice. Of these techniques, net present value, or
NPV, offers the best single indicator of the investment alternative’s potential contribution to the value of the firm.
Investment
Criterion Definition Decision Rule Advantages Disadvantages
Net present The present value of Accept investments that Is theoretically correct in Is somewhat complicated
value (NPV) expected cash inflows have a positive NPV. that it measures directly to compute (requires an
minus the present the increase in value that understanding of the time
value of expected cash the project is expected to value of money). Is not
outflows. produce. Measures the familiar to managers without
increase in shareholder formal business education.
wealth expected from
undertaking the project being
analyzed.
Equivalent The annual cost that is Select the investment Provides a tool that can be Should be used only where
annual cost equivalent in present alternative that has the used to account for different the investments being
(EAC) or value to the initial cost lowest annual cost. initial costs of purchase, compared are expected to be
equivalent and annual cash flows of different annual costs of used indefinitely. For single-
annual annuity an investment. operation, and different use investments, the NPV is
(EAA) productive lives. appropriate.
Profitability The present value of When the PI is greater Is theoretically correct in Is not as familiar to
index (PI) expected future cash than 1, the NPV will be that it measures directly managers as the NPV. Does
flows divided by the positive, so the project the increase in value that not add any additional
initial cash investment. should be accepted. the project is expected to information to the NPV.
When PI is less than produce. Is useful when
1, the NPV will be rank ordering positive-NPV
negative, which indicates projects where capital is
a bad investment, and being rationed.
the project should be
rejected.
Internal rate of The discount rate that Accept the project if the Provides a rate-of-return Cannot always be estimated.
return (IRR) makes the NPV equal to IRR is greater than the metric, which many Sometimes provides multiple
zero. required rate of return managers prefer. rates of return for projects
or discount rate used to with multiple changes in
calculate the net present the sign of their cash flows
value of the project, and over time. Can provide
reject it otherwise. results that conflict with the
NPV for mutually exclusive
projects.
Modified The discount rate that Accept the project if the Always produces a single The rate of return produced
internal rate of makes the NPV of the MIRR is greater than the rate-of-return estimate. by the MIRR is not unique
return (MIRR) modified cash flow required rate of return to the project because it is
stream equal to zero. or discount rate used to influenced by the discount
calculate the net present rate used to discount the
value of the project, and negative cash flows.
reject it otherwise.
Payback period The number of years If the project payback Is easy to understand and Ignores the time value of
required to recover the period is less than the calculate. Indicates risk by money. Ignores cash flows
initial cash outlay out maximum the firm will showing how long it takes to beyond the payback period.
of project future cash accept, the project is recover the investment. There is no rational way to
flows. acceptable. determine the cutoff value for
payback.
Discounted The number of years If the discounted project Same as payback period. Same as the last two items
payback period required to recover the payback period is less Also, by discounting the cash above. Also, because cash
initial cash outlay out of than the maximum the flows, this measure takes inflows must be discounted,
project discounted future firm will accept, the into account the time value discounted payback is more
cash flows. project is acceptable. of money. complicated to compute than
payback.
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Figure 11.2 provides the results of a survey of the chief financial officers (CFOs) of large
U.S. firms, showing the popularity of the payback period, discounted payback period, NPV,
PI, and IRR methods for evaluating capital investment opportunities. The results show that
the IRR and NPV methods are by far the most widely used methods, although more than half
the firms surveyed did use the payback period method. The survey reported that larger firms
tended to use the NPV and IRR more frequently than their smaller counterparts and that the
smaller firms tended to rely more on the payback period.
The popularity of the payback period may derive from its simplicity; however, an alter-
nate explanation is that it is used in combination with the NPV or IRR as a secondary method
to control for project risk. The logic behind this is that the payback period method empha-
sizes early-period cash inflows, which are generally more certain—have less risk—than cash
inflows occurring later in a project’s life. Managers believe its use will lead to projects with
more certain cash flows.
Figure 11.2
Survey of the Popularity of Capital-Budgeting Methods
These survey results are based on the survey responses of 392 chief financial officers of large U.S.
firms. These CFOs were asked if they used any of the following standard techniques. Specifically, they
were asked how frequently they used different capital-budgeting techniques on a scale of 0 to 4 (with 0
meaning “never,” 1 “almost never,” 2 “sometimes,” 3 “almost always,” and 4 “always”). The results below
are the percentages of the CFOs who said they always or almost always used a particular method.
Profitability index
Discounted payback period
Payback period
NPV
IRR
0% 10% 20% 30% 40% 50% 60% 70% 80%
Source: John Graham and Campbell Harvey, “How Do CFOs Make Capital Budgeting and Capital Structure
Decisions?” Journal of Applied Corporate Finance 15, no. 1 (Spring 2002): 8–23.
>> END FIGURE 11.2
Before you begin end-of-chapter material

1. What is the most widely used measure of capital budgeting in business practice?
2. How does the payback period method provide an indication of the risk of an investment proposal?
M11_TITM2189_13_GE_C11.indd 389 18/05/17 12:47 PM

390
Applying the Principles of Finance to Chapter 11
11
P Principle 1: Money Has a Time Value The value of an asset P Principle 3: Cash Flows Are the Source of Value The
or an investment proposal is equal to the present value of the future cash flows, calculation of the value of an asset or an investment proposal begins with an
discounted at the required rate of return. As a result, Principle 1 plays a pivotal estimation of the amount and timing of expected future cash flows. These free
role in making investment decisions. cash flows are then discounted back to present at the required rate of return.
C H A P T E R
P Principle 2: There Is a Risk-Return Tradeoff Different P Principle 5: Individuals Respond to Incentives Man-
projects have different levels of risk associated with them, and we deal with this agers respond to the incentives, and when their incentives are not properly
by increasing the discount rate when calculating the present value of the proj- aligned with those of the firm’s stockholders, they may not make investment
ect’s future cash flows. decisions that are consistent with increasing shareholder value.
Chapter Summaries
11.1 Understand how to identify the sources and types of profitable investment
opportunities. (pgs. 362–364)
Concept Check | 11.1 SUMMARY: Before a profitable project can be adopted, it must be identified. In general, the best
source of ideas for potentially profitable investments is the firm itself. Specifically, the firm’s mar-
1. What does the term capital keting and operations employees are rich sources of investment ideas.
budgeting mean?
2. Describe the two-phase
process typically involved in
carrying out a capital-budgeting
analysis.
3. What makes a capital-
budgeting project a good one?
4. What are the three basic types
of capital investment projects?
11.2 Evaluate investment opportunities using the net present value and
describe why it is the best measure to use. (pgs. 364–372)
SUMMARY: The net present value (NPV) of an investment proposal is equal to the present value
of its cash flows (including the initial cash outlay in Year 0, CF0):
CF1 CF2 CFn
NPV = CF0 + + + g + (11–1)
11 + k2 1 11 + k2 2 11 + k2 n
where CFt is the expected cash flow for periods t equal to 0, 1, 2, and so forth; k is the required rate
of return or discount rate used in calculating the present value of the project’s expected future cash
flows; and n is the last cash flow used to value the investment opportunity. If the computed NPV is
greater than zero, this indicates that the project creates value for the firm and its shareholders and
therefore is an acceptable investment opportunity.
KEY TERMS
Capital rationing, page 368 A situation in Mutually exclusive projects, page 366
which a firm’s access to capital is limited, so it is Related or dependent investment proposals
Concept Check | 11.2 unable to undertake all projects that have positive where the acceptance of one proposal means the
NPVs. rejection of the other.
1. Describe what the NPV tells the Equivalent annual cost (EAC), page Net present value (NPV), page 364 The
analyst about a new investment
opportunity.
369 The annuity cash flow amount that is equiva- difference in the present value of an investment
lent to the present value of the project’s costs. proposal’s future cash flows and the initial cash
2. What is the equivalent annual outlay. This difference is the expected increase in
cost (EAC) measure, and when Independent investment project, page
366 An investment project whose acceptance the value of the firm due to the acceptance of the
should it be used?
will not affect the acceptance or rejection of any project.
3. What is capital rationing?
other project.
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KEY EQUATIONS
Net Present Cash Flow for Year 1 1CF1 2 for Year 2 1CF2 2 for Year n 1CFn 2
= + + + g + (11–1)
Value or (NPV) for Year 0 1CF0 2 Discount 1 Discount 2 Discount n
a1 + b a1 + b a1 + b
Rate 1k2 Rate 1k2 Rate 1k2
¯˚˚˚˚˚˚˚˚˚˚˚˚˚˚˘˚˚˚˚˚˚˚˚˚˚˚˚˚˚˙
Cost of making the investment = Initial Present value of the investment’s cash inflows =
cash flow (this is typically a cash outflow, Present value of the project’s future cash inflows
taking on a negative value)
Equivalent NPV NPV

= =
Annual Cost 1EAC2 11 + k2 + 11 + k2 + g + 11 + k2
1 2 n Present Value of an Annuity
Discount Factor
NPV
= (11–2)
1 1
a - b
k k11 + k2 n
11.3 Use the profitability index, internal rate of return, and payback criteria to
evaluate investment opportunities. (pgs. 372–387)
SUMMARY: The profitability index (PI) is closely related to the NPV. Specifically, instead of
subtracting the initial cash outlay from the present value of future cash flows, the PI divides the
present value of the future cash flows by the negative of the initial outlay, CF0. The profitability
index can be expressed as follows:
Present Value of Future Cash Flows
Profibility Index 1PI2 =
Initial Cash Outlay
Using the symbols we used earlier to define NPV, we define the PI as follows:
CF1 CF2 CF3 CFn

+ + + g +
11 + k2 1
11 + k2 2
11 + k2 3 11 + k2 n
PI = (11–3)
- CF0
The decision criterion is this: Accept the project if the PI is greater than 1.00, and reject the project
if the PI is less than 1.00.
The internal rate of return (IRR) attempts to answer this question: “What rate of return is an
investment expected to earn?” For computational purposes, the IRR is defined as the discount rate
that results in an NPV of zero:
CF1 CF2 CF3 CFn

NPV = CF0 + + + + g+ = 0 (11–4)
11 + IRR2 1 11 + IRR2 2 11 + IRR2 3 11 + IRR2 n
The decision rule for using the IRR is the following: Accept the project if the IRR is greater
than the required rate of return, which is equal to the discount rate used to value (discount) the
project’s future cash flows, and reject the project if the IRR is less than this discount rate.
There are circumstances, however, where the IRR cannot be calculated or where there are
multiple discount rates that satisfy the definition of the IRR in Equation (11–4). The problem
of multiple estimates of the IRR arises when project cash flows change signs multiple times
over the life of the project. Some firms that want to use a rate-of-return criterion have adopted
M11_TITM2189_13_GE_C11.indd 391 18/05/17 12:47 PM

the use of the modified internal rate of return (MIRR) as a means to avoid the problem of
multiple IRRs. The MIRR addresses this problem by combining cash flows until there is only
one sign change. Specifically, negative cash flows are discounted back to Year 0 using the
discount rate used in calculating the NPV before calculating the MIRR of the altered cash flow
pattern.
The payback period criterion measures how quickly the project will return its original invest-
ment, and this is a very useful piece of information because it indicates something about the risk of
the investment. The longer the firm has to wait to recover its investment, the more things that can
happen that might reduce or eliminate the benefits of making the investment. However, using the
payback period as the sole criterion for evaluating whether to undertake an investment has three
fundamental limitations. First, the payback period calculation ignores the time value of money, as
it does not require that the future cash flows be discounted back to the present. Second, it does not
take into account how much cash flow is expected to be generated by the project beyond the end of
the payback period. Finally, there is no clear-cut way to define the cutoff criterion for the payback
period that is tied to the value-creation potential of the investment.
To deal with the criticism that the payback period method ignores the time value of money,
some firms use the discounted payback period approach. The discounted payback period method
is similar to that of the traditional payback period except that it uses discounted cash flows to cal-
culate the payback period. Thus, the discounted payback period is defined as the number of years
needed to recover the initial cash outlay from the discounted cash flows. However, the discounted
payback period approach still ignores cash flows beyond the payback period, and there is still no
clear-cut way to define the cutoff criterion for discounted payback.
KEY TERMS
Discounted payback period, page 385 The NPV profile, page 379 A plot of multiple
number of years required for a project’s dis- NPV estimates calculated using a succession of
counted cash flows to recover the initial cash different discount rates. This profile illustrates
outlay for an investment. when there are multiple IRRs—that is, where the
Internal rate of return (IRR), page NPV is equal to zero for more than one discount
374 The compound annual rate of return earned rate.
by an investment. Payback period, page 384 The number of
Modified internal rate of return (MIRR), years of future cash flows needed to recover the
page 380 The compound annual rate of return initial investment in a proposed project.
earned by an investment whose cash flows have Profitability index (PI), page 372 The
been moved through time so as to eliminate the ratio of the present value of the expected future
problem of multiple IRRs. For example, all nega- cash flows for an investment proposal (dis-
tive cash flows after Year 0 are discounted back counted using the required rate of return for the
to Year 0 using the firm’s required rate of return, project) divided by the initial investment in the
and then the IRR is determined for this modified project.
cash flow stream.
KEY EQUATIONS
Concept Check | 11.3 for Year 1 1CF1 2 for Year 2 1CF2 2 for Year n 1CFn 2
+ + g + (11–3)
1. Describe what the IRR metric Discount 1 Discount 2 Discount n
a1 + b a1 + b a1 + b
tells the analyst about a new Profitability Rate 1k2 Rate 1k2 Rate 1k2
investment opportunity. =
Index 1PI2 Initial Cash Outlay 1 - CF0 2
2. Describe the situations in which
the NPV and IRR metrics can
provide conflicting signals. Cash Flow Cash Flow
3. What is the modified internal Net Present Cash Flow for Year 1 1CF1 2 for Year 2 1CF2 2
rate of return metric, and why is = + +
Value for Year 0 1CF0 2 Internal Rate 1 Internal Rate 2
it sometimes used? a1 + b a1 + b
4. What is the payback period
of Return 1IRR2 of Return 1IRR2
method, and what is the source
of its appeal? Cash Flow
5. What is the discounted for Year n 1CFn 2
payback period method, and + g + = 0 (11–4)
how does it improve on the Internal Rate n
a1 + b
payback period measure? of Return 1IRR2
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11.4 Understand current business practice with respect to the use

of capital-budgeting criteria. (pgs. 387–389)
SUMMARY: Recent survey evidence from large U.S. firms on the popularity of the standard
Concept Check | 11.4 methods for evaluating capital investment opportunities showed that the IRR and NPV are by
1. What is the most widely used far the most widely used. However, more than half the firms surveyed use the payback period
measure of capital budgeting in method. Larger firms use the NPV and IRR more frequently than their smaller counterparts, and
business practice? smaller firms tend to rely more on the payback period. Finally, most firms use multiple invest-
2. How does the payback period ment criteria and often use the payback period as a secondary measure to reflect project risk
method provide an indication considerations.
of the risk of an investment
proposal?
Study Questions
11–1. In Regardless of Your Major: Making Personal Investment Decisions on page 362,
what were the types of personal decisions discussed that can be addressed using
capital-budgeting analyses?
11–2. Why might it be difficult for firms to find good investment ideas?
11–3. Distinguish between revenue enhancement investments, cost-reduction investments,
and mandated investments.
11–4. How is the presence or absence of product market competition that a firm faces
related to the NPV of the firm’s investment opportunities? What are the types of
barriers to competition (market entry) that tend to preserve positive NPVs?
11–5. Why is the NPV generally considered to be the preferred method for evaluating new
capital investment proposals? Describe the meaning of the NPV to a close relative
who has no business background in terms they would understand.
11–6. What does it mean to say that two or more investment projects are mutually
exclusive?
11–7. What are the limitations of the payback period as an investment decision criterion?
What are its advantages? Why do you think it is used so frequently?
11–8. Briefly compare and contrast the NPV, PI, and IRR criteria. What are the advantages
and disadvantages of using each of these methods?
11–9. If a project’s payback period is less than the maximum payback period that the firm
will accept, does this mean that the project’s NPV will also be positive?
11–10. What is the rationale for using the MIRR as opposed to the IRR decision criterion?
Describe the fundamental shortcoming of the MIRR method.
11–11. In Finance for Life: Higher Education as an Investment in Yourself on page 384, the
decision to get a college education was discussed in the context of an investment de-
cision. Discuss the analogy in more detail by identifying the initial cash outlay(s) and
the future benefits of your investment in higher education.
11–12. Discuss the merits and shortcomings of using the payback period for capital budget-
ing decisions.
11–13. What are the most widely used methods for evaluating capital expenditure projects in
practice?
11–14. Some analysts argue that the payback period criterion is actually a measure of project
risk. What is the logic behind this belief?
M11_TITM2189_13_GE_C11.indd 393 18/05/17 12:47 PM

Study Problems
MyLab Finance Net Present Value
Go to www.myfinancelab.com
to complete these exercises online 11–1. (Calculating NPV) (Related to Checkpoint 11.1 on page 367) Dowling Sportswear is
and get instant feedback. considering building a new factory to produce aluminum baseball bats. This project will
require an initial cash outlay of $8,000,000 and will generate annual net cash inflows of
$2,000,000 per year for six years. Calculate the project’s NPV for each of the following
discount rates:
a. 9 percent
b. 11 percent
c. 13 percent
d. 15 percent
11–2. (Calculating NPV) Carson Trucking is considering whether to expand its regional service
center in Moab, Utah. The expansion will require the expenditure of $10,000,000 on
new service equipment and will generate annual net cash inflows by reducing operating
costs $2,500,000 per year for each of the next eight years. In Year 8, the firm will also
get back a cash flow equal to the salvage value of the equipment, which is valued at $1
million. Thus, in Year 8 the investment cash inflow will total $3,500,000. Calculate the
project’s NPV using each of the following discount rates:
a. 9 percent
b. 11 percent
c. 13 percent
d. 15 percent
11–3. (Calculating NPV) Big Steve’s Swizzle Sticks is considering the purchase of a new
plastic-stamping machine. This investment will require an initial outlay of $100,000 and
will generate net cash inflows of $18,000 per year for 10 years.
a. What is the project’s NPV using a discount rate of 12 percent? Should the project be
accepted? Why or why not?
b. What is the project’s NPV using a discount rate of 13 percent? Should the project be
accepted? Why or why not?
c. What is this project’s IRR? Should the project be accepted? Why or why not?
11–4. (Calculating EAC) (Related to Checkpoint 11.2 on page 370) Barry Boswell is a finan-
cial analyst for Dossman Metal Works, Inc., and he is analyzing two alternative con-
figurations for the firm’s new plasma cutter shop. The two alternatives, denoted A and
B below, will perform the same task, but alternative A will cost $80,000 to purchase,
while alternative B will cost only $55,000. Moreover, the two alternatives will have
very different cash flows and useful lives. The after-tax costs for the two projects are
as follows:
Year Alternative A Alternative B

0 $(80,000) $(55,000)
1 (20,000) (6,000)
2 (20,000) (6,000)
3 (20,000) (6,000)
4 (20,000)
5 (20,000)
6 (20,000)
7 (20,000)
a. Calculate each project’s EAC, given a 10 percent discount rate.

b. Which of the alternatives do you think Barry should select? Why?
M11_TITM2189_13_GE_C11.indd 394 24/06/17 1:06 PM

11–5. (Calculating EAC) The Templeton Manufacturing and Distribution Company of

Tacoma, Washington, is contemplating the purchase of a new conveyor belt system
for one of its regional distribution facilities. Both the alternatives it is considering
will accomplish the same task, but the Eclipse model will cost substantially more
than the Sabre model and will not have to be replaced for 10 years, whereas the
Sabre model will need to be replaced in just 5 years. The costs of purchasing the
two systems and the costs of operating them annually over their expected lives are
as follows:
Year Eclipse Sabre

0 (1,400,000) (800,000)
1 (25,000) (50,000)
2 (30,000) (50,000)
3 (30,000) (60,000)
4 (30,000) (60,000)
5 (40,000) (80,000)
6 (40,000)
7 (40,000)
8 (40,000)
9 (40,000)
10 (40,000)
a. Templeton typically evaluates investments in plant improvements using a 12 per-

cent required rate of return. What are the NPVs for the two systems?
b. Calculate the EACs for the two systems.
c. Based on your analysis of the two systems using both their NPVs and their EACs,
which system do you recommend that the company pick? Why?
Other Investment Criteria

11–6. (Calculating IRR) (Related to Checkpoint 11.1 on page 367) What are the IRRs for
the following projects?
a. An initial outlay of $10,000 resulting in a single cash inflow of $17,182 in
8 years
b. An initial outlay of $10,000 resulting in a single cash inflow of $48,077 in
10 years
c. An initial outlay of $10,000 resulting in a single cash inflow of $115,231 in
20 years
d. An initial outlay of $10,000 resulting in a single cash inflow of $13,680 in
3 years
11–7. (Calculating IRR) Determine the IRRs for the following projects:
a. An initial outlay of $10,000 resulting in a cash inflow of $1,993 at the end of each
year for the next 10 years
b. An initial outlay of $10,000 resulting in a cash inflow of $2,054 at the end of each
c. An initial outlay of $10,000 resulting in a cash inflow of $1,193 at the end of each
d. An initial outlay of $10,000 resulting in a cash inflow of $2,843 at the end of each
11–8. (Calculating NPV and IRR) (Related to Checkpoint 11.1 on page 367) East Coast
Television is considering a project with an initial outlay of $X (you will have to
determine this amount). It is expected that the project will produce a positive cash
M11_TITM2189_13_GE_C11.indd 395 18/05/17 12:47 PM

flow of $50,000 at the end of each year for the next 15 years. The appropriate dis-
count rate for this project is 10 percent. If the project has a 14 percent IRR, what is
the project’s NPV?
11–9. (Calculating IRR) (Related to Checkpoint 11.4 on page 376) Determine the IRR to
the nearest percent for the following projects:
a. An initial outlay of $10,000 resulting in cash inflows of $2,000 at the end of Year
1, $5,000 at the end of Year 2, and $8,000 at the end of Year 3
b. An initial outlay of $10,000 resulting in cash inflows of $8,000 at the end of Year
1, $5,000 at the end of Year 2, and $2,000 at the end of Year 3
c. An initial outlay of $10,000 resulting in cash inflows of $2,000 at the end of
Years 1 through 5 and $5,000 at the end of Year 6
11–10. (Calculating IRR) Jella Cosmetics is considering a project that will cost $800,000
and is expected to last for 10 years and produce future cash flows of $175,000 per
year. If the appropriate discount rate for this project is 12 percent, what is the proj-
ect’s IRR?
11–11. (Calculating IRR) Your investment advisor has offered you an investment that
will provide you with a single cash flow of $10,000 at the end of 20 years if
you pay premiums of $200 per year in the interim period. Specifically, the an-
nual premiums will begin immediately and extend through the end of Year 19.
You will then receive the $10,000 at the end of Year 20. Find the IRR for this
investment.
11–12. (Calculating IRR and NPV) (Related to Checkpoint 11.1 on page 367 and Checkpoint
11.4 on page 376) The cash flows for three independent projects are as follows:
Year Project A Project B Project C

0 (initial investment) $(50,000) $(100,000) $(450,000)
1 $ 10,000 $ 25,000 $ 200,000
2 15,000 25,000 200,000
3 20,000 25,000 200,000
4 25,000 25,000 —
5 30,000 25,000 —
a. Calculate the IRR for each of the projects.

b. If the discount rate for all three projects is 10 percent, which project or projects
would you want to undertake?
c. What is the NPV of each of the projects where the appropriate discount rate is
10 percent? 20 percent?
11–13. (Calculating IRR, payback, and a missing cash flow) The Merriweather Printing
Company is trying to decide on the merits of constructing a new publishing facil-
ity. The project is expected to provide a series of positive cash flows for each of
the next four years. The estimated cash flows associated with this project are as
follows:
Year Project Cash Flow

0 ?
1 $800,000
2 400,000
3 300,000
4 500,000
If you know that the project has a regular payback period of 2.5 years, what is the
project’s IRR?
M11_TITM2189_13_GE_C11.indd 396 23/05/17 11:03 AM

11–14. (Calculating MIRR) (Related to Checkpoint 11.6 on page 382) Emily’s Soccer Ma-
nia is considering building a new indoor soccer facility for local soccer clubs to rent.
This project will require an initial cash outlay of $10 million and will generate an-
nual cash inflows of $3 million per year for Years 1 through 5. In addition, in Year 5
the project will require an additional investment outlay of $5,000,000. During Years
6 through 10, the project will provide cash inflows of $5 million per year. Calculate
the project’s MIRR, given the following:
a. A discount rate of 10 percent
b. A discount rate of 12 percent
c. A discount rate of 14 percent
11–15. (Calculating MIRR) OTR Trucking runs a fleet of long-haul trucks and has recently
expanded into the Midwest, where it has decided to build a maintenance facility.
This project will require an initial cash outlay of $20 million and will generate an-
nual cash inflows of $4.5 million per year for Years 1 through 3. In Year 4, the
project will provide a net negative cash flow of $5,000,000 due to anticipated ex-
pansion of and repairs to the facility. During Years 5 through 10, the project will
provide cash inflows of $2 million per year.
a. Calculate the project’s NPV and IRR where the discount rate is 12 percent. Is the
project a worthwhile investment based on these two measures? Why or why not?
b. Calculate the project’s MIRR. Is the project a worthwhile investment based on
this measure? Why or why not?
11–16. (Calculating IRR for an uneven cash flow stream) Microwave Oven Programming,
Inc., is considering the construction of a new plant. The plant will have an initial
cash outlay of $7 million (CF0 = -$7 million) and will produce cash flows of $3
million at the end of Year 1, $4 million at the end of Year 2, and $2 million at the
end of Years 3 through 5. What is the IRR for this new plant?
11–17.
(Calculating MIRR) (Related to Checkpoint 11.6 on page 382) The Dunder Muffin
Company is considering purchasing a new commercial oven that costs $350,000.
This new oven will produce cash inflows of $125,000 at the end of Years 1 through
10. In addition to the cash inflows, at the end of Year 5 there will be a net cash out-
flow of $200,000. The company has a required rate of return of 12 percent. What is
the MIRR of the investment? Would you make the investment? Why or why not?
11–18. (Calculating MIRR) Star Industries owns and operates landfills for several municipali-
ties throughout the U.S. Midwest. Star typically contracts with the municipality to
provide landfill services for a period of 20 years. The firm then constructs a lined
landfill (required by federal law) that has capacity for 5 years. The $10 million
expenditure required to construct the new landfill results in negative cash flows at
the end of Years 0, 5, 10, and 15. This change in sign on the stream of cash flows
over the 20-year contract period introduces the potential for multiple IRRs, so Star’s
management has decided to use the MIRR to evaluate new landfill investment con-
tracts. The annual cash inflows to Star begin in Year 1 and extend through Year 20
and are estimated to equal $3 million (this does not reflect the cost of constructing
the landfills every 5 years). Star uses a 10 percent discount rate to evaluate its new
projects, so it plans to discount all the construction costs every 5 years back to Year
0 using this rate before calculating the MIRR.
a. What are the project’s NPV, IRR, and MIRR?
b. Is this a good investment opportunity for Star Industries? Why or why not?
11–19.
(Calculating NPV, PI, and IRR) (Related to Checkpoint 11.1 on page 367 and
Checkpoint 11.4 on page 376) Fijisawa, Inc., is considering a major expansion
of its top-selling product line and has estimated the following cash flows associ-
ated with the expansion. The initial outlay will be $10,800,000, and the project
will generate cash flows of $1,250,000 per year for 20 years. The appropriate
discount rate is 9 percent.
a. Calculate the NPV.
b. Calculate the PI.
c. Calculate the IRR.
d. Should this project be accepted? Why or why not?
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11–20. (Calculating the discounted payback period) Gio’s Restaurants is considering a proj-
ect with the following expected cash flows:
Year Project Cash Flow

0 $(150 million)
1 90 million
2 70 million
3 90 million
4 100 million
I f the project’s appropriate discount is 12 percent, what is the project’s discounted

payback period?
11–21. (Calculating the discounted payback period) The Callaway Cattle Company
is considering the construction of a new feed-handling system for its feed-
lot in Abilene, Kansas. The new system will provide annual labor savings
and reduced waste totaling $200,000, and the initial investment will be only
$500,000. Callaway’s management has used a simple payback period method
for evaluating new investments in the past but plans to calculate the discounted
payback period to analyze the investment. Where the appropriate discount
rate for this type of project is 10 percent, what is the project’s discounted pay-
back period?
11–22. (Calculating the payback and discounted payback periods) The Bar-None Manufac-
turing Company manufactures fence panels used in cattle feedlots throughout the
Midwest. Bar-None’s management is considering three investment projects for next
year but doesn’t want to make any investment that requires more than three years
to recover the firm’s initial investment. The cash flows for the three projects (A, B,
and C) are as follows:
Year Project A Project B Project C

0 $(1,000) $(10,000) $(5,000)
1 600 5,000 1,000
2 300 3,000 1,000
3 200 3,000 2,000
4 100 3,000 2,000
5 500 3,000 2,000
a. Given Bar-None’s three-year payback period, which of the projects will qualify
for acceptance?
b. Rank the three projects using their payback periods. Which project looks the best
using this criterion? Do you agree with this ranking? Why or why not?
c. If Bar-None uses a 10 percent discount rate to analyze projects, what is the dis-
counted payback period for each of the three projects? If the firm still maintains
its three-year payback policy for the discounted payback, which projects should
the firm undertake?
11–23. (Calculating the payback period and NPV) Plato Energy is an oil-and-gas explora-
tion and development company located in Farmington, New Mexico. The company
drills shallow wells in hopes of finding significant oil and gas deposits. The firm is
considering two different drilling opportunities that have very different production
potentials. One is in the Barnett Shale region of central Texas, and the other is on
the Gulf Coast. The Barnett Shale project requires a much larger initial investment
but provides cash flows (if successful) over a much longer period of time than the
Gulf Coast opportunity. In addition, the longer life of the Barnett Shale project
results in additional expenditures in Year 3 of the project to enhance production
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throughout the project’s 10-year expected life. This expenditure involves pumping
either water or CO2 down into the wells in order to increase the flow of oil and gas.
The expected cash flows for the two projects are as follows:
Year Barnett Shale Gulf Coast

0 $(5,000,000) $ (1,500,000)
1 2,000,000 800,000
2 2,000,000 800,000
3 (1,000,000) 400,000
4 2,000,000 100,000
5 1,500,000
6 1,500,000
7 1,500,000
8 800,000
9 500,000
10 100,000
a. What is the payback period for each of the two projects?

b. Based on the calculated payback periods, which of the two projects appears to be
the better alternative? What are the limitations of the payback period ranking?
That is, what does the payback period not consider that is important in determin-
ing the value-creation potential of these two projects?
c. If Plato’s management uses a 20 percent discount rate to evaluate the present
values of its energy investment projects, what are the NPVs of the two proposed
investments?
d. What is your estimate of the value that will be created for Plato by the accep-
tance of each of these two investments?
11–24. (Calculating the payback period, NPV, PI, and IRR) You are considering a project
with an initial cash outlay of $80,000 and expected cash flows of $20,000 at the end
of each year for six years. The discount rate for this project is 10 percent.
a. What are the project’s payback and discounted payback periods?
b. What is the project’s NPV?
c. What is the project’s PI?
d. What is the project’s IRR?
11–25. (Using NPV for mutually exclusive projects) You have been assigned the task of
evaluating two mutually exclusive projects with the following projected cash flows:
Year Project A Cash Flow Project B Cash Flow

0 $(100,000) $(100,000)
1 33,000 0
2 33,000 0
3 33,000 0
4 33,000 0
5 33,000 220,000
If the appropriate discount rate on these projects is 10 percent, which would be

chosen and why?
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11–26. (Calculating NPV, PI, and IRR) (Related to Checkpoint 11.1 on page 367,
Checkpoint 11.3 on page 374, and Checkpoint 11.4 on page 376) You are consid-
ering two independent projects, Project A and Project B. The initial cash
outlay associated with Project A is $50,000, and the initial cash outlay associated
with Project B is $70,000. The discount rate on both projects is 12 percent. The
expected annual cash flows from each project are as follows:
Year Project A Project B

0 $(50,000) $(70,000)
1 12,000 13,000
2 12,000 13,000
3 12,000 13,000
4 12,000 13,000
5 12,000 13,000
6 12,000 13,000
Calculate the NPV, PI, and IRR for each project, and indicate if either project should
be accepted.
11–27.
(Solving a comprehensive problem) Garmen Technologies Inc. operates a small
chain of specialty retail stores throughout the U.S. Southwest. The company
markets technology-based consumer products both in its stores and over the
internet, with sales split roughly equally between the two channels of distribu-
tion. The company’s products range from radar detection devices and GPS map-
ping systems used in automobiles to home-based weather monitoring stations.
The company recently began investigating the possible acquisition of a regional
warehousing facility that could be used both to stock its retail shops and to make
direct shipments to the firm’s online customers. The warehouse facility would
require an expenditure of $250,000 for a rented space in Oklahoma City, Okla-
homa, and would provide cash flows over the next 10 years. The estimated cash
flows are as follows:
Year Cash Flow Year Cash Flow

0 $(250,000) 6 $65,000
1 60,000 7 65,000
2 60,000 8 65,000
3 60,000 9 65,000
4 60,000 10 90,000
5 (45,000)
The negative cash flow in Year 5 reflects the cost of a planned renovation and
expansion of the facility. Finally, in Year 10 Garmen estimates some recovery of
its investment at the close of the lease and, consequently, a higher-than-usual cash
flow. Garmen uses a 12 percent discount rate in evaluating its investments.
a. As a preliminary step in analyzing the new investment, Garmen’s management
decided to evaluate the project’s anticipated payback period. What is the project’s
expected payback period? Jim Garmen, CEO, questioned the analyst performing
the analysis about the meaning of the payback period because it seems to ignore
the fact that the project will provide cash flows over many years beyond the end
of the payback period. Specifically, he wanted to know what useful information
the payback period provides. If you were the analyst, how would you respond to
Mr. Garmen?
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b. In the past, Garmen’s management has relied almost exclusively on the IRR to
make its investment choices. However, in this instance the lead financial analyst
on the project suggested that there may be a problem with the IRR because the
sign on the cash flows changes three times over its life. Calculate the IRR for the
project. Evaluate the NPV profile of the project for discount rates of 0 percent, 20
percent, 50 percent, and 100 percent. Does there appear to be a problem of mul-
tiple IRRs in this range of discount rates?
c. Calculate the project’s NPV. What does the NPV indicate about the potential
value created by the project? Describe to Mr. Garmen what the NPV means,
recognizing that he was trained as an engineer and has no formal business
education.
Mini-Cases
RWE Enterprises: Expansion Project Analysis flow to the firm, so the full 10-year cash flows for the line are
RWE Enterprises, Inc. (RWE), is a small manufacturing firm as follows:
located in the hills just outside of Nashville, Tennessee. The
Year After-Tax Cash Flow
firm is engaged in the manufacture and sale of feed supplements
used by cattle raisers. The product has a molasses base but is 0 $(3,000,000)
supplemented with minerals and vitamins that are generally 1 700,000
thought to be essential to the health and growth of beef cattle. 2 700,000
The final product is put in 125-pound or 200-pound tubs,
3 700,000
which are then made available for the cattle to lick as desired.
The material in the tub becomes very hard, which limits the 4 700,000
animals’ consumption. 5 (1,300,000)
The firm has been running a single production line for the 6 700,000
past 5 years and is considering the addition of a new line. The
7 700,000
addition would expand the firm’s capacity by almost 120 percent
because the newer equipment requires a shorter downtime 8 700,000
between batches. After each production run, the boiler used to 9 700,000
prepare the molasses for the addition of minerals and vitamins 10 900,000
must be heated to 180 degrees Fahrenheit and then cooled
down before beginning the next batch. The total production a. If RWE uses a 10 percent discount rate to evaluate invest-
run entails about four hours, and the cool-down period is two ments of this type, what is the NPV of the project? What
hours (during which time the whole process comes to a halt). does this NPV indicate about the potential value RWE
Using two production lines increases the overall efficiency of might create by adding the new production line?
the operation because workers from the line that is cooling down
can be moved to the other line to support the “canning” process b. Calculate the IRR and PI for the proposed investment. What
involved in filling the feed tubs. do these two measures tell you about the project’s viability?
The equipment for the second production line will cost $3 c. Calculate the payback and discounted payback periods for
million to purchase and install and will have an estimated life the proposed investment. Interpret your findings.
of 10 years, at which time it can be sold for an estimated after-
tax scrap value of $200,000. Furthermore, at the end of 5 years Jamie Dermott: Mutually Exclusive
the production line will have to be refurbished at an estimated Project Analysis
cost of $2 million. RWE’s management estimates that the new
Jamie Dermott graduated from Midland State University in June
production line will add $700,000 per year in after-tax cash
and has been working for about a month as a junior financial
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analyst at Caledonia Products. When Jamie arrived at work on Ethics Case: Ford’s Pinto and the Value of Life
Friday morning, he found the following memo in his e-mail: In 1968, Ford Motor Company (F) executives decided to produce
TO: Jamie Dermott a subcompact car called the Pinto in response to the onslaught
FROM: V. Morrison, CFO, Caledonia Products of Japanese economy cars. Known inside the company as “Lee’s
RE: Capital-Budgeting Analysis car,” after Ford President Lee Iacocca, the Pinto was to weigh no
more than 2,000 pounds and cost no more than $2,000.
Provide an evaluation of two proposed projects with the fol- Eager to have its subcompact ready for the 1971 model year,
lowing cash flow forecasts: Ford decided to compress the normal drafting-board-to-show-
room time from three-and-a-half years down to only two. The
compressed schedule meant that design changes typically made
Year Project A Project B
before production-line tooling would have to be made during it.
0 (initial outlay) $(110,000) $(110,000) Before producing the Pinto, Ford crash tested 11 cars, in part to
1 20,000 40,000 learn if they met the National Highway Traffic Safety Administra-
2 30,000 40,000 tion’s (NHTSA) proposed safety standard that all autos be able to
withstand a fixed-barrier impact of 20 miles per hour without fuel
3 40,000 40,000
loss. Eight standard-design Pintos failed these tests. The three cars
4 50,000 40,000 that passed the test all had some kind of gas-tank modification. The
5 70,000 40,000 first had a plastic baffle between the front of the tank and the differ-
ential housing, the second had a piece of steel between the tank and
the rear bumper, and the third had a rubber-lined gas tank.
Because these projects involve additions to Caledonia’s
Ford officials faced a tough decision. Should they go ahead
highly successful Avalon product line, the company requires a
with the standard design, thereby meeting the production timetable
rate of return on both projects equal to 12 percent. As you are
but possibly jeopardizing consumer safety? Or should they delay
no doubt aware, Caledonia relies on a number of criteria when
production of the Pinto and redesign the gas tank to make it safer?
evaluating new investment opportunities. In particular, we re-
If they chose the latter course of action, they would effectively con-
quire that projects that are accepted have a payback period
cede another year of subcompact dominance to foreign companies.
of no more than three years, provide a positive NPV, and have
To determine whether to proceed with the original design of
an IRR that exceeds the firm’s discount rate.
the Pinto fuel tank, Ford compared the expected costs and benefits
Give me your thoughts on these two projects by 9 a.m.
of making the change. Would the benefits of a new tank design
Monday morning.
outweigh its costs or not? To find the answer, Ford estimated the
Jamie was not surprised by the memo, for he had been ex- costs of the design improvement to be $11 per vehicle. The ben-
pecting something like this for some time. Caledonia followed efit to Ford of having a safer gas tank relates to the avoidance
a practice of testing each new financial analyst with some type of the potential costs Ford might incur in the event of a fatality
of project evaluation exercise after the new hire had been on the resulting from a fuel tank rupture if the auto was involved in an
job for a few months. accident. To determine this benefit, Ford analyzed the dollar value
After rereading the memo, Jamie decided on his plan of of the average loss resulting from a traffic fatality. The NHTSA
attack. Specifically, he would first do the obligatory calcu- had estimated a cost of $200,725 every time a person was killed in
lations of payback period, NPV, and IRR for both projects. an auto accident. The costs were broken down as follows:
Jamie knew that the CFO would grill him thoroughly on Mon-
day morning about his analysis, so he wanted to prepare well Future Productivity Losses
for the experience. One of the things that occurred to Jamie Direct $132,000
was that the memo did not indicate whether the two projects Indirect 41,300
were independent or mutually exclusive. So, just to be safe,
he thought he had better rank the two projects in case he was Medical Costs
asked to do so on Monday morning. Jamie sat down and made Hospital 700
up the following “to do” list: Other 425
Property damage 1,500
1. Compute payback period, NPV, and IRR for both projects. Insurance administration 4,700
2. Evaluate the two projects’ acceptability using all three deci- Legal and court expenses 3,000
sion criteria (listed above) and basing the conclusion on the Employer losses 1,000
assumption that the projects are independent—that is, that
Victim’s pain and suffering 10,000
both could be accepted if both are acceptable.
Funeral 900
3. Rank the two projects and make a recommendation as to
Assets (lost consumption) 5,000
which (if either) should be accepted under the assumption
Miscellaneous accident costs 200
that the projects are mutually exclusive.
Total per fatality $200,725a
Assignment: Prepare Jamie’s evaluation for his Monday a
Ralph Drayton, “One Manufacturer’s Approach to Automobile Safety
meeting with the CFO by completing his “to do” list. Standards,” CTLA News 8, no. 2 (February 1968): 11.
M11_TITM2189_13_GE_C11.indd 402 18/05/17 12:47 PM

Ford analysts used NHTSA’s estimates and other statistical Because the $137.5 million cost of the safety improvement
studies in their cost-benefit analysis, which yielded the follow- outweighed the $49.5 million benefit of the redesign, Ford decided
ing estimates: to push ahead with the original design.
Benefits Losses avoided by redesigning the fuel tank

in the Pinto
Questions
Savings: 180 burn deaths; 180 serious burn injuries; 1. Do you think Ford analyzed the problem of redesigning the
and 2,100 burned vehicles Pinto fuel tank in a reasonable way?
Unit cost: $200,000 per death; $67,000 per injury; and
$700 per vehicle 2. Should questions involving the risk of loss of human life
be answered using a cost-benefit analysis? After all,
Total benefit: (180 * $200,000) + (180 * $67,000) +
(2,100 * $700) = $49.5 million don’t life insurance companies do this all the time in
pricing life insurance policies to older versus younger
Costs Losses incurred by the redesign of the fuel
customers?
tank in the Pinto
Sales: 11 million cars; 1.5 million light trucks Source: This case is based on William Shaw and Vincent Barry, “Ford’s Pinto,”
Moral Issues in Business, 9th ed. (New York: Wadsworth, 2004), 84–86. © by
Unit cost: $11 per car and $11 per truck
Wadsworth, Inc.
Total cost: 12.5 million * $11 = $137.5 milliona
a
Mark Dowie, “Pinto Madness,” Mother Jones, September–October 1977,
20. See also Russell Mokhiber, Corporate Crime and Violence (San Fran-
cisco: Sierra Club Books, 1988), 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).
M11_TITM2189_13_GE_C11.indd 403 18/05/17 12:47 PM

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Part 1 Introduction to Financial Management Part 4 Capital Structure and Dividend Policy

(Chapters 1, 2, 3, 4) (Chapters 15, 16)

Part 3 Capital Budgeting (Chapters 11, 12, 13, 14)

Investment Decision Criteria

11.2 Net Present Value Objective 2. Evaluate investment opportunities using

11.4 A Glance at Actual Capital- Objective 4. Understand current business practice

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M11_TITM2189_13_GE_C11.indd 361 19/07/17 2:13 PM

Regardless of Your Major…

Your Turn: See Study Question 11–1.

11.1 An Overview of Capital Budgeting

M11_TITM2189_13_GE_C11.indd 362 18/05/17 12:47 PM

Lesson 3: Successful investment choices lead to the development of managerial

The Typical Capital-Budgeting Process

What Are the Sources of Good Investment Projects?

Types of Capital Investment Projects

M11_TITM2189_13_GE_C11.indd 363 18/05/17 12:47 PM

Before you move on to 11.2

Concept Check | 11.1

11.2 Net Present Value

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Why Is the NPV the Right Criterion?

Calculating an Investment’s NPV

Cash Flow Cash Flow

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Tools of Financial Analysis—Net Present Value

Independent Versus Mutually Exclusive

Evaluating Mutually Exclusive Investment Opportunities

M11_TITM2189_13_GE_C11.indd 366 18/05/17 12:47 PM

Calculating the Net Present Value for Project Long

STEP 1: Picture the problem

Time Period 0 1 2 3 4 5 Years

Cash Flow –$100,000 $70,000 $30,000 $30,000 $25,000 $10,000

STEP 2: Decide on a solution strategy

$70,000 $30,000 $30,000 $25,000 $10,000

Data and Key Input Display

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NPV (0.17,70000,30000,30000,25000,10000) - 100000 = $18,378

STEP 5: Check yourself

ANSWER: NPV = $573,817.

Choosing Between Mutually Exclusive Investments

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CF1 CF2 CFn

We can also solve for EAC using a financial calculator as follows:

Solve for EAC

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Calculating the Equivalent Annual Cost

STEP 1: Picture the problem

Project Long (Five-Year Life):

Time Period 0 1 2 3 4 5 Years

Cash Flow –$30,000 –$3,000 –$3,000 –$3,000 –$3,000 –$3,000

Project Short (Three-Year Life):

Time Period 0 1 2 3 Years

Cash Flow –$22,000 –$4,000 –$4,000 –$4,000

STEP 2: Decide on a solution strategy

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The three-year project’s EAC can be computed in the same way:

Data and Key Input Display

Data and Key Input Display