CHAPTER 3

INVESTMENT APPRAISAL

CONCEPT QUESTIONS:
1. Incremental Cash Flows Which of the following should be treated as an incremental cash flow
when computing the NPV of an investment?
a. A reduction in the sales of a company’s other products caused by the investment. Yes (OC)
b. An expenditure on plant and equipment that has not yet been made and will be made only if the
project is accepted. Yes
c. Costs of research and development undertaken in connection with the product during the past three
years. No (sunk cost)
d. Annual depreciation expense from the investment. No ( non-cash items)
e. Dividend payments by the firm.No, always have to pay at the end of the year
f. The resale value of plant and equipment at the end of the project’s life. Yes
g. Salary and medical costs for production personnel who will be employed only if the project
is accepted. Yes
2. Incremental Cash Flows Your company currently produces and sells steel shaft golf clubs. The
board of directors wants you to consider the introduction of a new line of titanium bubble
woods with graphite shafts. Which of the following costs are not relevant?
a. Land you already own that will be used for the project, but otherwise will be sold for $700,000, its
market value. Yes (OC)
b. A $300,000 drop in your sales of steel shaft clubs if the titanium woods with graphite shafts are
introduced. Yes (OC)
c. $200,000 spent on research and development last year on graphite shafts. No (Sunk cost)
3. Comparing Investment Criteria Define each of the following investment rules and
discuss any potential shortcomings of each. In your definition, state the criterion for
accepting or rejecting independent projects under each rule.
a. Payback period.
b. Internal rate of return.
c. Profitability index.
d. Net present value.
4. Net Present Value You are evaluating Project A and Project B. Project A has a short period of
future cash flows, while Project B has relatively long future cash flows. Which project will be more
sensitive to changes in the required return? Why? (ĐỌC DURATION)
5. Payback and Internal Rate of Return A project has perpetual cash flows of C per period, a cost
of I, and a required return of R. What is the relationship between the project’s payback and its
IRR? What implications does your answer have for long-lived projects with relatively constant cash
flows?
6. Net Present Value The investment in Project A is $1 million, and the investment in Project B is $2
million. Both projects have a unique internal rate of return of 20 percent. Is the following statement
true or false? For any discount rate from 0 percent to 20 percent, Project B has an NPV twice as great
as that of Project A.

EXERCISES
1. Calculating Discounted Payback An investment project has annual cash inflows of $5,000,
$5,500, $6,000, and $7,000, and a discount rate of 12 percent. What is the discounted payback
period for these cash flows if the initial cost is $8,000? What if the initial cost is $12,000? What if it
is $16,000?
2. NPV versus IRR Consider the following cash flows on two mutually exclusive projects for
the Bahamas Recreation Corporation (BRC). Both projects require an annual return of 14 percent.

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As a financial analyst for BRC, you are asked the following questions:
a. If your decision rule is to accept the project with the greater IRR, which project should you
choose?
b. Because you are fully aware of the IRR rule’s scale problem, you calculate the incremental IRR
for the cash flows. Based on your computation, which project should you choose?
c. To be prudent, you compute the NPV for both projects. Which project should you choose? Is it
consistent with the incremental IRR rule?
3. Comparing Investment Criteria Wii Brothers, a game manufacturer, has a new idea for an
adventure game. It can market the game either as a traditional board game or as an interactive
DVD, but not both. Consider the following cash flows of the two mutually exclusive projects for
the company. Assume the discount rate for both projects is 10 percent.

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

b. Based on the NPV, which project should be chosen?
c. Based on the IRR, which project should be chosen?
d. Based on the incremental IRR, which project should be chosen?
4. Profitability Index versus NPV Hanmi Group, a consumer electronics conglomerate, is
reviewing its annual budget in wireless technology. It is considering investments in three different
technologies to develop wireless communication devices. Consider the following cash flows of the
three independent projects available to the company. Assume the discount rate for all projects is 10
percent. Further, the company has only $40 million to invest in new projects this year.

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

b. Based on the NPV, rank these investments.
c. Ba≥sed on your findings in (a) and (b), what would you recommend to the CEO of the company
and why?
5. Payback and NPV An investment under consideration has a payback of six years and a cost of
$573,000. If the required return is 12 percent, what is the worst-case NPV? The best-case NPV?
Explain. Assume the cash flows are conventional.
6. Calculating IRR Consider two streams of cash flows, A and B. Stream A’s first cash flow is
$11,600 and is received three years from today. Future cash flows in Stream A grow by 4 percent in
perpetuity. Stream B’s first cash flow is -$13,000, is received two years from today, and will
continue in perpetuity. Assume that the appropriate discount rate is 12 percent.
a. What is the present value of each stream?
b. Suppose that the two streams are combined into one project, called C. What is the IRR
of Project C?
c. What is the correct IRR rule for Project C?
7. Calculating Project NPV The Best Manufacturing Company is considering a new
investment. Financial projections for the investment are tabulated here. The corporate tax rate is 34
percent. Assume all sales revenue is received in cash, all operating costs and income taxes are paid
in cash, and all cash flows occur at the end of the year. All net working capital is recovered at the
end of the project.

a. Compute the incremental net income of the investment for each year.
b. Compute the incremental cash flows of the investment for each year.
c. Suppose the appropriate discount rate is 12 percent. What is the NPV of the project?
8. Project Evaluation Dog Up! Franks is looking at a new sausage system with an
installed cost of $345,000. This cost will be depreciated straight-line to zero over the project’s five-
year life, at the end of which the sausage system can be scrapped for $25,000. The sausage
system will save the firm $85,000 per year in pretax operating costs, and the system requires an
initial investment in net working capital of $20,000. If the tax rate is 34 percent and the discount
rate is 10 percent, what is the NPV of this project?
9. Calculating NPV Howell Petroleum is considering a new project that complements its existing
business. The machine required for the project costs $3.9 million (Initial investment). The
marketing department predicts that sales related to the project will be $2.35 million per year for the
next four years(Sales revenue), after which the market will cease to exist. The machine will be
depreciated down to zero over its four-year economic life using the straight-line method. Cost of
goods sold and operating expenses related to the project are predicted to be 25 percent of
sales(COGS & Operating cost) . Howell also needs to add net working capital of $150,000
immediately. The additional net working capital will be recovered in full at the end of the project’s
life. The corporate tax rate is 35 percent. The required rate of return for Howell is 13
percent(Discount rate). Should Howell proceed with the project?
10. Calculating EAC You are evaluating two different silicon wafer milling machines. The
Techron I costs $245,000, has a three-year life, and has pretax operating costs of $39,000 per year.
The Techron II costs $315,000, has a five-year life, and has pretax operating costs of $48,000 per
year. For both milling machines, use straight-line depreciation to zero over the project’s life and
assume a salvage value of $20,000. If your tax rate is 35 percent and your discount rate is 9 percent,
compute the EAC for both machines. Which do you prefer? Why?
11. NPV, IRR, PI
GoodMan Enterprise is planning to implement an investment project, the total initial investment
capital is $10,510, of which: fixed assets investment is $9,000 and working capital is $1,510. The
operation period of the project is 4 years, the annual profit after tax generated by the project is
$2,900. (Earning before tax By the end of the project, the fixed assets can be sold at $800. The cost
of capital of the project is 10%/year(Discount rate) and the corporate income tax rate is 20%.
Calculate the NPV, IRR, PI of the investment project and state whether the company should make
this investment? Knowing that the enterprise uses straight line depreciation.
12. NPV
A company specializing in the production of sports equipment is working on setting up a
production line with an expected life span of 5 years. The estimated figures are as follows:
- Investment in procurement of 100 specialized machines: The purchase price (without VAT) is
$80,000/machine. (Initial Investment)
- The installation of the machine is carried out on an existing land of the company. If not used for
the project, the land can be leased with an estimated net income of $130,000/year (OC)
- Initial working capital investment is $190,000.
- Annual revenue is estimated at $410,00.
- Operating expenses (excluding depreciation) are $280,230/year.
- The corporate income tax rate is 20%.
- The company applies the straight-line depreciation method.
- The average capital cost of the project is 10%/year
Based on the NPV, should the company make this investment?
13. NPV, PI
Phoenix company is working on an investment of a new product line. It is estimated that the
production of this new product requires the company to procure a machine for $7,500 with a 5-year
life span. By the end of the project, the machine can be sold at $700. At the same time, the company
must also invest $1,000 in working capital. Annual revenue from new products is estimated to be
$2,200. However, if this new product is put into production, it could help stimulate the consumption
of other current products, thus increasing the revenue of these products by $500 annually. Annual
operating expenses (excluding depreciation) is $970.
The company applies the straight-line depreciation method. The average cost of capital is 10% per
year and the CIT rate is 20%.
Requirement: Determine the NPV and PI of the project and advise the company whether to invest in
this new product or not?
14. NPV, IRR
Company X is currently considering whether to buy a new machine or continue using the old one:
- The old machine has the original price of $200,000, and has been depreciated by 40%( Còn lại
120000) . Its current market price is $90,000. If continued to use, this machine can generate
$70,000 in profixt before tax per year(EBT). After 4 more years, it will have to be liquidated, the
estimated liquidation value is $10,000.
- If buying the new machine, the estimated investment capital is $300,000. The company also needs
to invest another $50,000 in working capital. The total estimated lifespan of the machine is 6 years.
Each year, estimated annual profit before tax is $95,000. It is estimated that after 4 years of use, it
can be sold for $30,000.
The company applies the straight-line depreciation method and the CIT rate is 20%. The cost of
capital is 10%/year. The company needs to use either of the machines for only 4 years.
Requirement: Please advise the company whether to buy the new machine or not using the NPV
and IRR?