Capital Budgeting Process and Techniques 93

Chapter 7: Capital Budgeting Process and Techniques

Answers to questions
7-1. a. Type I error means rejecting a good project. Payback could lead to Type 1 errors when
it rejects a good project that has large cash flows after the payback period cutoff.
Payback ignores cash flows after the cutoff.
b. Type II error means accepting a project that should have been rejected. Type II errors
occur when payback says to accept a project that doesnt return enough to compensate
for the risk taken. This occurs because payback makes no adjustments for risk or time
value of money.
c. If firms apply the payback rule with a fairly short cutoff period! then a type I error is
more likelygood projects with higher cash flows in later years may be rejected. "n
the other hand! if firms apply the payback rule but use a long cutoff period! then a Type
II error becomes more likely because the payback method makes no adjustment for the
time value of money.
7-#. $iscounted payback has a more severe biasdiscounted cash flows will be smaller! making it
even harder for a project to pass the payback hurdle. %or e&ample! if the cutoff period is four
years! then every project that satisfies the discounting payback rule will also satisfy payback!
but the reverse is not true.
7-'. The (P) approach is consistent with shareholder ma&imi*ation because it suggests that firms
should only accept projects that earn returns above the opportunity costs of the firm+s investors.
The (P) in effect measures the dollar contribution that the given project is e&pected to make to
the firm+s overall value. If a firm invests in a project with (P) , -.! then the share price will
rise. /onversely! a firm+s share price will fall if it invests in projects with (P) 0 -..
7-1. It is true that long-term projections are more prone to error than are short-term projections.
2owever! there are two reasons why this simple truth does not lead to the conclusion that the
payback approach is superior to (P). %irst! the payback approach itself implicitly makes long-
term cash flow projections. 3pecifically! the payback approach forecasts *ero cash flows
beyond the payback hori*on. The real 4uestion is not whether long-term forecasts are more or
less accurate than short-term forecasts are! but whether a long-term forecast can be more
accurate than a na5ve guess of *ero. 3econd! via discounting! the (P) approach makes an
adjustment for the high degree of risk in long-term projections. The farther into the future that a
given project+s cash flows arrive! the less valuable those cash flows are in an (P) calculation.
(P) automatically adjusts for project time by using an e&ponentially smaller discount rate
applied to later cash flows.
7-6. 7ny method can be manipulated. 3mart managers must be aware of this and must be prepared
to press analysts to justify their numbers. "pportunities to manipulate the numbers are not
uni4ue to the (P) approach and can therefore not be used to justify payback! accounting rate of
return! or any other approach over (P). It would be hard to argue that accounting numbers
can+t be manipulated after all the accounting scandals! starting with 8nron in late #..1.
9anagers should have incentives to provide the most accurate information possible.
7-:. a. 7 firm that consistently earns returns higher than its opportunity cost of capital is
adding value to the firm! and its stock returns should increase. 3tock returns should be
well above average for companies of this risk level.
94 Chapter 7
b. %or the project returning 1;<! as long as it returns enough to compensate for the risk of
the project! it is adding value and shareholders will be happy about the decision to
accept the project.
7-7. The I== suffers from several problems. The I== is not well suited to ranking projects with
very different scales or projects with very different cash flow timing patterns due to the
reinvestment assumption. The I== method can also yield no solution or multiple solutions that
are hard to interpret. $espite the flaws! the I== method enjoys widespread use because in most
investment situations it generates reliable accept>reject recommendations and it is easy to
interpret intuitively. The 9I== method uses a more realistic reinvestment rate. 7lso! there can
be only one 9I== for a project.
7-;. ?ecause the discounted payback period e4uals the life of the projected! the sum of all of the
discounted cash flows must e4ual the cost of the project. This indicates that the (P) must also
be *ero and that the I== e4uals 1.< because the (P) is *ero.
7-@. The (P) is the most appropriate capital budgeting method because it yields correct
accept>reject situations and correct project rankings. (evertheless! it is somewhat less intuitive
than the I==. In projects with cash flow streams that switch signs! the I== method can yield
multiple solutions. In those cases! it is difficult for a firm to know whether to accept or reject a
project based upon its I==.
7-1.. The (P) is calculated by discounting all of a project+s cash flows to the present. The I== is
calculated by finding the discount rate! which e4uates the (P) to *ero. The profitability inde&
is the ratio of the present value of a project+s cash flows Ae&cluding the initial cash outflowB
divided by the initial cash outflow. 7ll three methods lead to the same accept>reject decision
when evaluating a single project! but I== and PI have problems when ranking projects. (P)
generally overcomes these problems.
7-11. I==! (P)! and PI can lead to different decisions when they are used to rank projects or to select
between mutually e&clusive projects. I== and PI methods are not well suited to evaluating
projects that vary in scale. The (P) method yields correct project rankings no matter what the
scale of the project.
7-1#. If an unlimited capital budget e&ists! firms should always accept every independent project with
(P) , -.. Chen funds are limited! firms should select the group of projects which has the
highest aggregate (P) yet stays within the budget constraint.
7-1'. Project 7 recovers its cost in # years and Project ? recovers its cost in ' years. /onse4uently!
the payback period for Project 7 is two years and the payback period for Project ? is three years
making Project 7 preferred based on the shortest payback period criteria. 2owever! Project ?
is the better project because of the -1.!...... cash flow in the fourth year. The problem with
the payback criteria is that it does not encompass all of the cash flows of the project.
Answers to problems
7-1. a. If the computers are depreciated on a straight-line basis! depreciation will be -6!... per
year for 1 years. /ontribution to net income will beD
Eear 1 Eear # Eear ' Eear 1
Capital Budgeting Process and Techniques 95
-7!6.
.
-@!1
..
-@!1
..
-@!1
..
F
6!...
F
6!..
.
F
6!..
.
F
6!..
.
-#!6..
-1!1
..
-1!1
..
-1!1
..
The average net income is A-#!6.. G -1!1.. G -1!1.. G -1!1..B>1 H -'!7..
b. The average book value of the investment is A-#.!... G .B># H -1.!....
c. The average accounting rate of return H 7verage net income>7verage book value of the
investment H -'!7..>-1.!... H .'7 or '7<.
d. The payback period is #.'7 years! based on cash flow numbers! not net income.
e. This is not an appropriate method for evaluating capital budgeting projects. It does not
take time value of money into account! nor does it look at cash flows. It also does not
consider the risk of the project and what would be an appropriate discount rate in light
of the projects cash flows.
7-#. a. Payback on this bond is #6 years. Eou pay -1!...I you receive -1. a year for #6 years!
a total of -1!....
b. The bond is not necessarily a bad investment. Payback does not take time value of
money into account! nor does it account for cash flows received after the payback
period. It is more appropriate to calculate the (P) of an investment. Jiven the risk
level of the bond! is 1< a fair returnK If the answer is yes! then the bond may be a good
investment.
c. The discounted payback! using a 1< discount rate! is '. years. This shows that unless
the acceptable payback period is decreased when discounted payback is used! vs.
regular payback! then projects that return money late in the life of the investment are
even more disadvantaged under discounted payback than under regular payback. (P)
is a more appropriate method to use to determine the value of an investment project.
The general rule is that when a project+s discounted payback period is the same as its
life! then the (P) must be *ero.
7-'. a. Payback of 7lpha H '.6 years! payback of ?eta H #.6 years! payback of Jamma H '.''
years
b. If the cutoff is ' years! then only ?eta is acceptable. If the cutoff is 1 years! then all of
the projects are acceptable.
c. ?eta has the fastest payback.
d. If the firm uses discounted payback with a cutoff of 1 years! then 7lpha will payback in
96 Chapter 7
more than 6 years! ?eta in just under ' years and Jamma in between 1 and 6 years.
This means only ?eta is acceptable. /alculations are shown in the table that follows.
Capital Budgeting Process and Techniques 97
7lpha A-1!6..!...B ?eta A-1..!...B Jamma A-7!6..!...B
8nd
of
Eear
/%
P) of
/% L
16<
/um P) /%
P) of
/% L
16<
/um
P)
/%
P) of /%
L 16<
/um P)
1 '..M -#:.!;7. -#:.!;7. 1..M -;:!@67 -;:!@67 #!...M-1!7'@!1'. -1!7'@!1'.
# 6..M '7;!.7# :';!@1# #..M 1:6!@@7 #6#!@61 '!...M ##:!;1'1 1!..7!6:1
' 6..M '#;!76; @:7!7.. #..M 161!##@ 1.1!1;' #!...M 1!'16!.'# 6!'##!6@'
1 1..M ##;!7.1 1!1@:!1.1 1..M :;!;;7 17'!.7. 1!6..M ;67!:'. :!1;.!##'
6 '..M 11@!16' 1!'61!661 -#..M -1#6!617 '17!66' 6!6..M #!7'1!17# ;!@11!:@6
$isc
Pay-
back
,6 years
=eject
,' N 1 years 0
7ccept
,1 N 6 years0
=eject
e. Project ?eta should be rejected. Eou must pay out a total of .: million and take in .:
million. Chen there is a time value to money! in other words! a positive interest rate!
this is unacceptable. If cash inflows and outflows are the same! this is a negative net
present value project.
f. Project Jamma is rejected using discounted payback Aas noted in d.B! but even without
discounting! seems to have a high dollar return for the investment. Eou pay -7.6
million and receive a total of -11 million in cash inflows. Onless the firm has a very
high discount rate! greatly lowering the value of the last -6.6 million cash flow! this is
likely to be an attractive investment.
7-1. a. To determine the accounting rate of return A77=B we need to first determine the annual
net income by subtracting the depreciation from the /ash %low! as shown in the table
below.
7sset 7 7sset ?
-#..!... P # H -1..!... -1;.!... P # H -@.!...
Eear /% $epr.
(et
Income /% $epr.
(et
Income
1 -7.!... -1.!... -'.!... -;.!... -':!... -11!...
# -;.!... -1.!... -1.!... -@.!... -':!... -61!...
' -@.!... -1.!... -6.!... -'.!... -':!... -A:!...B
1 -@.!... -1.!... -6.!... -1.!... -':!... -1!...
6 -1..!... -1.!... -:.!... -1.!... -':!... -1!...
7verage H -1:!... 7verage H -#.!...
7==7 H -1:!... P -1..!... H 1:<
7==? H -#.!... P -@.!... H ##.##<
Jiven that the minimum acceptable 7== is '.<! only 7sset 7 is acceptable.
b.
7sset 7 7sset ?
Eear /ash %lows 7mount still to /ash %lows 7mount still to
9 Chapter 7
be recovered be recovered
.
--#..!... --1;.!...
1
-7.!... A-1'.!...B -;.!... A-1..!...B
#
-;.!... A-6.!...B -@.!... A-1.!...B
'
-@.!... -'.!...
1
-@.!... -1.!...
6
-1..!... -1.!...
7sset 7 has -6.!... left to be recovered after year #! or ..6: of year '. Thus! 7sset
7+s payback is #.6: years. 7sset ? has -1.!... to be recovered after year #! or ..'' of
year '. 7sset ?+s payback period is #.'' years. 7ccording to the ma&imum payback
period re4uirement of #.6 years! only 7sset ? is acceptable.
c.
Eear 7sset 7
7sset ?
$iscounted
/ash %lows
7mount still to
be recovered
$iscounted
/ash %lows
7mount still to
be recovered
. A-#..!...B A-1;.!...B
1 -:#!6.. A-1'7!6..B -71!1#@ A-1.;!671B
# -:'!77: A-7'!7#1B -71!717 A-':!;#1B
' -:1!.:. A-@!::1B -#1!'6' A-16!171B
1 -67!1@7 -#6!1#1
6 -6:!71' -##!:@7
7fter the third year! 7sset 7 still has -@!::1 left to be recovered. This represents ..17
of the yearI thus! 7sset 7+s discounted payback period is '.17 years. 7sset ? still needs
to recover -16!171 after the third year. This is ..:1 of the fourth year. Thus! 7sset ?+s
discounted payback period is '.:1 years. 7sset 7 is acceptable according to the firm+s
ma&imum discounted payback period.
d. 7ll the evaluation methods suffer from serious flaws. The firm should re-evaluate the
projects using the (P) method or the 9I== method.
7-6. a. This project has /%. H F-16!...! and #. inflows of -1'!.... 7t a 11< discount rate!
its (P) is -71!1...7.. This is a positive (P) and an acceptable project.
b. This project has /%. H F-'#!... and #. inflows of -1!.... 7t 11<! its (P) is F
-6!6.7.1;. This is a negative (P) and is not acceptable.
c. This project has /%. H F-6.!...! and #. inflows of -;!6... 7t a 11< discount rate! its
(P) is -:!#@:.:1. This is a positive (P) and an acceptable project.
7-:. /%. H F-1@!...
/ash flows of -1!...>year for ; years.
a. (P) at 1.< H -#!''@.7.! accept
Capital Budgeting Process and Techniques 99
b. (P) at 1#< H -;7..6:! accept
c. (P) at 11< H F-111.61! reject
"nly positive (P) projects are acceptable. 7s the discount rate increases! (P) decreases. 7t
some point! if the discount rate is high enough! a previously acceptable project at lower discount
rates may become unacceptable.
7-7. $iscount rate H 11<
Project (P) $ecision
7
F
-1!'61.:6
=eject
?
-:7!:7;.#
1
7ccept
/
F
-71!7@;..
7
=eject
$
-@;!1;@.;
#
7ccept
8 -;!61;.11 7ccept
7-;. $iscount rate H 16<
Project (P) $ecision
7
F
-6!#6'.67
=eject
? -#!1#1.#7 7ccept
/
-17!@@#.@
6
7ccept
Project / is the best! followed by Project ?. Project 7 is the worst project! and is unacceptable.
7-@. (P) of project H -@!@7#!71#
/urrent firm value H -1. ! 1.!...!... H -1..!...!...
(ew firm value H -1..!...!... G -@!@7#!71# H -1.@!@7#!71#
(ew stock price H -1.@!@7#!71# > 1.!...!... H -11... per share
This project should add -1.!...!... or -1 per share to the firm+s overall value.
7-1.. The (P) of Project Q9( is -##6.#1D A--1.!...... G R-#!;#6... P A1 G 1#<BS G R-'!1@#.#6 P
A1 G 1#<B
#
S G R-'!:.7.#1 P A1 G 1#<B
'
S G R-1!.7:.1; P A1 G 1#<B
1
S H -##6.#1B.
The annual return is ;.1@<D AR-1'!7...:7 P -1.!......S
..#6
F 1 H ;.1@<
?ecause the cash flows are not reinvested. This is contrary to an implicit reinvestment
assumption in the (P) calculation. If the cash flows earned 1#< interest upon receipt then the
annual return would also be 1#<.
7-11. Project I==
7 17.1<
"## Chapter 7
? ;.7<
/ #7.#<
$ #1.1<
7-1#. a. Project 7D I== H 16.7<
Project ?D I== H 17.'<
b. Cith a cost of capital of 16<! both projects are acceptable.
c. Project ? has a higher I==! and is preferred to Project 7! based on the I== criterion.
7-1'. a. 7fter three years of cash flows! only -1#:.;7 of the fourth year cash flow is necessary
to recover the cost of the project. Thus! the payback period is '.'.#1 years A ' years G
A-1#:.;7 P -1!111!1;B yearsB.
b. The discounted payback period is 1 yearsD A--1!...... G R-1!.@.... P A1 G @<BS G
R-1!1;;.1. P A1 G @<B
#
S G R-1!#@6..' P A1 G @<B
'
S G R-1!111.6; P A1 G @<B
1
S H -....B.
cNd. This is e4uivalent to an (P) of *ero and an I== of @<.
7-11. The (P) for Project T is -....D A--:!...... G R-1!7#6... P A1 G 16<BS G R-1!@;'.76 P A1 G
16<B
#
S G R-#!#;1.'1 P A1 G 16<B
'
S G R-#!:#'.61 P A1 G 16<B
1
S H -....B. ?ecause the (P) is
*ero! the profitability inde& is 1..! the discounted payback period is 1 years Ai.e. the life of the
projectB! and the I== is 16<.
7-16.
Project (P) I==
=enovate
-1!1#;!'.
@
#..6<
=eplace -1''!77@ ':.1<
The =enovate project has a higher (P) and the =eplace project has a higher I==.
a. =anking on (P)D =enovate! =eplace
b. =anking on I==D =eplace! =enovate
c. The rankings provide mi&ed signals because of the differences in the site and timing of
the cash flow patterns and initial investments of the two projects. Projects that have
lower initial investments and return their cash flows earlier in the life of the project tend
to have higher I==s! as is the case with the =eplace project.
d. The incremental project has the following cash flowsD
Eear =enovate =eplace
=enovate -
=eplace
.
F
-@!...!..
.
F
-1!...!...
F-;!...!...
1 '!6..!... :..!... #!@..!...
Capital Budgeting Process and Techniques "#"
# '!...!... 6..!... #!6..!...
' '!...!... 1..!... #!:..!...
1 #!;..!... '..!... #!6..!...
6 #!6..!... #..!... #!'..!...
The I== of the incremental project is 1;.7<. This is greater than the discount rate of
16<. %or a conventional project! accept projects with I==s greater than the hurdle rate.
3ince the incremental project is acceptable! this means the project on top A=enovateB F
the one from which cash flows were subtracted! is the better project. This is consistent
with the (P) criterion F accept the project with the highest (P)! in this case! the
=enovate project.
7-1:.
a.
... ! #. -
B I== 1 A
... ! 1. -
B I== 1 A
... ! 6. -
. -
# 1

+

+
=
Qet
1
B I== 1 A
1
&
+
=
... ! #. - & ... ! 1. - & ... ! 6. - . -
#
=
# & & 6 . -
#
=
. # & 6 &
#
= +
Osing the 4uadratic formula
a&
#
G b& G c H .
a #
ac 1 b b
&
#

=
#
1# . 1 6
#
17 6
#
; #6 6
&
#
=

=

=
b. ?ecause the undiscounted (P) of the project is positive Ai.e.I -F#.!... G -6.!... F
-1.!... H -#.!...B the project will have a positive (P) at all discount rates between F
7;..7< and G1#7.#7<. Therefore the firm can accept the project as long as its cost of
capital falls between the two I==s.
c. To determine the 9I==! solve for the interest rate that e4uates the present value of the
outflows to the future value of the inflows! with the discount rate and compounding rate
e4ual to the firm+s cost of capital.
I== 1
1
6: . 1
+
=
1 I== 6: . 1 6: . 1 = +
6: . ' I== 6: . 1 =
=

=
6: . 1
6: . '
I==
1
F7;..7<
I== 1
1
11 . .
+
=
1 I== ..11 ..11 = +
..6: I== ..11 =
= =
..11
..6:
I==
#
< #7 . 1#7
"#$ Chapter 7
Eear /% %) L 16< P) L 16<
. -#.... A-#.!......B
1 6.... -67!6.....
# -1.... A-7!6:1.11B
-67!6..... A-#7!6:1.11B
-#7!6:1.11 H -67!6.. P RA1GiB
#
S
9I== H I H 11.11<
The project is acceptable according to the 9I==.
7-17. a.
... ! 1;. -
B 1 A
... ! 1#. -
B 1 A
... ! 6:. ! 1 -
. -
# 1

+

+
=
%&& %&&
Qet
1
B I== 1 A
1
&
+
=
... ! 1;. - ... ! 1#. - ... ! 6:. ! 1 - . -
#
= ! !
Osing the 4uadratic formula
a&
#
G b& G c H .
a #
ac 1 b b
&
#

=
... ! #1. -
'1; ! 1;1 ! 1 - ... ! 6:. ! 1 -
#

= !
b.
Interest
=ate (P)
. -@:.!......
6. -''7!777.7;
1.. -1'6!......
16. -1@!@#....
#.. -;!;;;.;@
#6. A-1#!6@1.76B
%&& +
=
1
1
:; . 1#
1 :; . 1# :; . 1# = + %&&
< 11 . @#
1
= %&&
I== 1
1
'16' . .
+
=
1 I== '16' . . '16' . . = +
< 1: . 17 # I==
#
=
Capital Budgeting Process and Techniques "#3
(P) Profile
A-#..!......B
-....
-#..!......
-1..!......
-:..!......
-;..!......
-1!...!......
-1!#..!......
. 6. 1.. 16. #.. #6. '..
Interest =ate
(
P
)
c. Ees! because at #6< the (P) is positive.
d. To determine the 9I==! solve for the interest rate that e4uates the present value of the
outflows to the future value of the inflows! with the discount rate and compounding rate
e4ual to the firm+s cost of capital.
Eear /% %) L 16< P) L 16<
. -1;.!... A-1;.!...B
1
1!6:.!..
. -1!7@1!...
# -1#.!... A-@.!7'7B
77< -1!7@1!... A-67.!7'7B
-67.!7'7 H -1!7@1!... P RA1GiB
#
S
9I== H I H 77.#@<
The project is acceptable according to the 9I==.
7-1;.
a. /ost of /apital Project (P)
. -.
6 -F1.'6
1. .
16 -..6:
#. .
#6 -F..:7#
'. .
'6 -'.1:
6. -11.1;
b.
"#4 Chapter 7
(P) Profile
-1.
.
1.
#.
'.
1.
6.
. #. 1. :.
/ost of /apital
(
P
)
c. The project has an I== at every point where it crosses the discount rate a&is! in this case
at .<! 1.<! #.< and '.<. The four I==s correspond to the four changes in sign of the
project+s cash flows.
d. This project is acceptable at discount rates between 1.< and #.< and when the
discount rate is greater than '.< in those cases the (P) is positive.
7-1@. The PIs at the end of each project are listed belowD
a. PI of Qi4uidate H -1';!1:1 > -1..!... H 1.';
PI of =econdition H -1.#!6:1 > -6..!... H ..;1
PI of =eplace H -1!111!:1' > -1!...!... H 1.11
b. 7ccept both Qi4uidate and =eplace because both have a PI , 1..
c. 7ccept Qi4uidate because it has the highest PI.
d. 7ccording to the (P)! the ranking would be =eplace! Qi4uidate and then =econdition.
If the projects are independent! =eplace and Qi4uidate are acceptable! while
=econdition is not viable. If the projects are mutually e&clusive! =eplace should be
chosen.
Qi4uidate =econdition =eplace
Eear /ash %low
$iscounted
L 16< /ash %low
$iscounted
L 16< /ash %low
$iscounted
L 16<
. -A1..!...B -A1..!...B -A6..!...B -A6..!...B -A1!...!...B -A1!...!...B
1 -6.!... -1'!17; -1..!... -;:!@67 -6..!... -1'1!7;'
# -:.!... -16!':@ -#..!... -161!##@ -6..!... -'7;!.7#
' -76!... -1@!'11 -#6.!... -1:1!'7@ -6..!... -'#;!76;
(P) -';!1:1 -A@7!1':B -111!:1'
e. Chen the projects are mutually e&clusive! the PI method and (P) method result in a
dilemma! as PI argues for Qi4uidate while (P) argues for =eplace. The reason for this
dilemma is due to the large scale differences in the projects.
Capital Budgeting Process and Techniques "#5
7-#.. a. (P)1 H F-1!...!... G -1!...!... ! A1.1#B
-1
G -#!...!... ! A1.1#B
-#
G -'!...!... !
A1.1#B
-'
H -:##!6;:
(P)# H F-6!...!... G -#!...!... ! A1.1#B
-1
G -'!...!... ! A1.1#B
-#
G -'!...!... !
A1.1#B
-'
H -1!'1#!:'7
(P)' H F-1.!...!... G -1!...!... ! A1.1#B
-1
G -:!...!... ! A1.1#B
-#
G -6!...!... !
A1.1#B
-'
H -1!@1'!1@' Rhighest (P)S
b. PI1 H -1!:##!6;: > -1!...!... H 1.1:
PI# H -:!'1#!:'7 > -6!...!... H 1.#: Rhighest PIS
PI' H -11!@1'!1@' > -1.!...!... H 1.1@
c. 7lthough Project U # provides Vmore bang for the buckW as represented by its higher PI!
Project U' should be accepted since it has the higher (P) and there are no other
investments under consideration. It adds most to the firm.
7-#1. The (P) of Project 7?/ is -;1;.1;D A--1!...... G R-#!...... P A1 G 1.<BS H -;1;.1;. The
(P) of Project X=3 is -#!......D A--1.!...... G R-1!1..... P A1 G 1.<BS G R-1!;1.... P A1 G
1.<B
#
S G R-6!'#1... P A1 G 1.<B
'
S H -#!......B.
The profitability inde& of Project 7?/ is 1.;1;D A 1 G R(P) P /ostS H 1 G R-;1;.1; P
-1!......S H 1.;1;B. The profitability inde& of Project X=3 is 1.#.D A1 G R-#!...... P
-1.!......S H 1.#.B.
?ased on (P)! Project X=3 is considered better. ?ased on profitability inde&! Project 7?/ is
better.
7-##. a. The discounted payback period for Project Y is ' years A': monthsBD A--'!'..... G
R-1!#'#... P A1 G 1#<BS G R-1.'7@.;1 P A1 G 1#<B
#
S G R-1!616.1# P A1 G 1#<B
'
S H
-....B. The discounted payback period for Project E is 1 years A1; monthsBD A-
-6!...... G R-1!11#.6. P A1 G 1'<BS G R-1!6@:.1' P A1 G 1'<B
#
S G R-1!;.'.:# P A1 G
1'<B
'
S G R-#!.';..@ P A1 G 1'<B
1
S H -....B.
b. Jiven the threshold of 1# months! Project Y is the better project.
c. The (P) of Project Y is -1!1.....D A--'!'..... G R-1!#'#... P A1 G 1#<BS G
R-1.'7@.;1 P A1 G 1#<B
#
S G R-1!616.1# P A1 G 1#<B
'
S G R-1!7'..;7 P A1 G 1#<B
1
S H
-1!1.....B. The (P) of Project E is -1!#6....D A--6!...... G R-1!11#.6. P A1 G 1'<BS
G R-1!6@:.1' P A1 G 1'<B
#
S G R-1!;.'.:# P A1 G 1'<B
'
S G R-#!.';..@ P A1 G 1'<B
1
S G
R-#!'.'..1 P A1 G 1'<B
6
SH -1!#6....B. Osing the (P) criteria! Project E is better.
d. The profitability inde& of Project Y is 1.'''D A 1 G R(P) P /ostS H 1 G R-1!1..... P
-'!'.....S H 1.'''B. The profitability inde& of Project E is 1.#6.D A 1 G R-1!#6.... P
-6!......S H 1.#6.B. ?ased on the profitability inde&! Project Y is better.
7-#'. Project /ash %lows Ain millionsBD
%low /ash
Eear

6 . 1 -
.

. . # -
1

. . # -
#

. . # -
'
a. 7t "ld Qines discount rate of 1.<! this project has an (P) of about -171!... and an
"#6 Chapter 7
I== of 16.@<. This project would be acceptable for "ld Qine.
c. 7t 2igh Techs #.< discount rate! the project (P) is about F-#;7!.... This makes the
project unacceptable to 2igh Tech due to its negative (P).
c. The cost of capital is very important to the acceptance of a project. 7 firm that has a
lower cost of capital will find more projects acceptable and! all other things e4ual! will
potentially add more value for shareholders.
7-#1.
/ash%low
Eear

... ! #. -
.

1.. ! 1 -
1

1.. ! 1 -
#

1.. ! 1 -
'

1.. ! 1 -
1

1.. ! 1 -
6

1.. ! 1 -
:

1.. ! 1 -
7
a. 7t 1.<! the (P) of the project is -1!1#1..1.
b. The I== is 1#.1'<
c. This project is acceptable by both (P) and I== criteria. It has a positive (P) and its
I== is greater than its hurdle rate of 1.<.
7-#6. a. The payback period is '.6: years.
End of Year CF Cum CF
years 6: . ' 6: . '
6.. ! '1 -
6.. ! :7 - ... ! ;6 -
yrs '
= +
=

+
1 -1;!... -1;!...
# ##!6.. 16!...
' #7!... :7!6..
1 '1!6.. @@!...
6 ':!... 1'6!...
b. (P) is -;!:7#.61
c. I== is 16.:<.
d. This project is acceptable by both (P) and I== criteria. It has a positive (P) and its
I== of 16.:< is greater than its hurdle rate of 1#<.
7-#:.
Project
a.
Payback
b.
(P)
c.
I==
Y
#.@:
years
-11!@:6.#
1
#..1<
E
'.17
years
-11!#.:.1
;
17.1<
T
'.'7
years
-:!#1..@1
11.76
<
Capital Budgeting Process and Techniques "#7
d. =anking on PaybackD Y!E!T
=anking on (P)D Y!E!T
=anking on I==D Y!E!T
7ll measures agree that Y is best! followed by E! and then and T. 3ince they are
mutually e&clusive projects! accept the project with the highest (P)! which is Project
Y.
7-#7.
Eea
r
7ll at once Jradual
.
F
-6!...!..
.
F
-1!...!...
1
F
-#!...!...
#
F
-#!...!...
'
F
-#!...!...
The (P) of the immediate program is F-6 million. The (P) of the phase-in program! at a
discount rate of 16<! is F-6.67 million. It is cheaper to implement the immediate pollution
control program.
7-#;. All measures indicate project acceptability.
NPV > 0
IRR >11%
PI > 1.00
The indicates the pre!erred project usin" each measure.
a. NPV
#$
% &'()*1*.'( NPV
+T
% &1,-)-.,.0(
b. IRR
#$
% 1/.0(% IRR
+T
% 1..1(%
c. PI
#$
% 1.1* PI
+T
% 1.1.
7sset 7 7sset ?
-#..!... -1;.!...
Eear /%
$iscounted
/% /%
$iscounted
/%
1 -7.!... -:#!6.. -;.!... -:#!6..
# -;.!... -:'!77: -@.!... -:'!77:
' -@.!... -:1!.:. -'.!... -:1!.:.
1 -@.!... -67!1@7 -1.!... -67!1@7
6 -1..!... -6:!71' -1.!... -6:!71'
"# Chapter 7
d. Timing issues result between the two projects because Project 3X receives a substantial
amount of inflows early in its life while the bulk of Project 2T+s cash flows do not
arrive until later in its life. The reinvestment rate assumption of the I== method leads
to a conflict between project choices for the I== method vs the (P) method. 7
scaling problem also e&ists in that 3X costs about 1.6 times that of 2T.
(P) Profile
-A1!...!...B
-A6..!...B
--
-6..!...
-1!...!...
.< #.< 1.< :.<
Interest =ate
(
P
)
3X
2T
e. The firm should choose Project 2T. %irst! according to the (P) Profile! at the 11<
discount rate! 2T has the higher (P). 3econdly! according to the 9I== calculation!
Project 2T has the higher 9I== A9I==3X H 1'.#@<! 9I==2T H 1'.:1<B.
7-#@. a. (P) of =epackage is -..';1 million. (P) of =eformulate is -..1.7. /hoose the
higher (P)! =epackage.
b. I== of =epackage is #1..1<. I== of =eformulate is 1'.#.<. /hoose the higher I==!
=epackage.
c. PI of =epackage is P) of inflows divided by P) of outflowsD -'!';1!'@.>-'!...!... H
1.1'. PI of =eformulate is -#6!1.#!1:'>-#6!...!... H 1...1. /hoose the higher PI!
=epackage.
d. 7t an interest rate of appro&imately 1#< =eformulate becomes less desirable than
=epackage. 7lso! it is clear from the Profile that =eformulate is far more sensitive to
the discount rate than =epackage. 7 timing problem e&ists in the sense that
=eformulate receives the bulk of its inflows early on. 7nd! a scaling problem e&ists in
that =epackage costs more than eight times =eformulate.
Capital Budgeting Process and Techniques "#9
(P) Profile
-A16!...!...B
-A1.!...!...B
-A6!...!...B
--
-6!...!...
-1.!...!...
.< 1.< #.< '.< 1.< 6.<
Interest =ate
(
P
)
=epackage
=eformulate
e. (o! the rankings do not yield mi&ed signals. =epackage is better under all criteria.
f. The I== of the incremental projectD
Eear =epackage =eformulate
=epackage -
=eformulate
.
F
-'!...!...
F
-#6!...!...
-##!...!...
1 #!...!... 1.!...!... F;!...!...
# 1!#6.!... @!...!... F7!76.!...
' 6..!... 7!...!... F:!6..!...
1 #6.!... 1!...!... F'!76.!...
6 #6.!... '.6..!... F'!#6.!...
The I== of the incremental project is its compound annual costs of 1#.';<. %or a
project of this type resulting from the smaller si*e of repackage versus reformulate! if
the I== is less than the discount rate! it is acceptable. =epackage is therefore the better
project because its incremental cost is less than the cost of capital.
7-'.. a.! b.! c.
Eear 7 ? 7-?
. F-#.6 F-#.6 .
1 1.: .'6 1.#6
# 1.: .'6 1.#6
' .'6 F.'6
.
.
.
.
""# Chapter 7
6. .'6 F.'6
Project (P) I== PI
7
-#7:!;:
.
1;.1:< -#7:!;:.>-#!6..!... H 1.11
?
-@7.!1;
6
1'.@;<
-'!17.!1;6>-#!6..!... H
1.'@
=ankingsD ?! 7 7! ? ?! 7
The PI rankings agree with the rankings on (P).
d. I== and (P) yield mi&ed signals because of differences in the si*e and magnitude of
their cash flows. Project 7 returns cash sooner than ?! a pattern that generally has a
higher I== than one! like ?! that returns cash flows over a longer period of time.
e. Qundblad should choose project 7. The (P) of the incremental project is F-:@'!'#:!
and its I== is 1'.1<. Chen a project has nonconventional cash flows AG inflows
followed by -outflowsB its I== is its compound annual costs. If this cost is greater than
the hurdle rate! the project is unacceptable. In this case the cost of 1'.1< is greater than
the 1.< cost of capital and therefore! Project 7 is inferior to Project ?.
f. If the cost of capital is 1'.6<! Project 7 has an (P) of -161!711 and an I== of
1;.1:<. 7t a cost of capital of 1:<! 7 has an (P) of -:;!'71. 7t a cost of capital of
1'.6<! Project ? has an (P) of -;7!@;. and at 1:<! F-'1'!;.@. Project 7 is better
than Project ? at a discount rate of 1'.6<. 7t 1:<! Project 7 is the only acceptable
project. 7t a cost of capital of #.<! Project 7+s (P) is F-66!66: and Project ?+s
(P) is F-76.!1@#I both projects should be rejected at this cost of capital.
7-'1. Thomson "ne ?usiness 3chool 8dition
7-'#. Thomson "ne ?usiness 3chool 8dition
Answers to mini'case
Payback period:
Poofy PuffsD
Initial outlayD -#1!;@.!...
7mount recovered in year 1D -1#!@6.!...
7mount remaining that needs to be recoveredD -#1!;@.!... - -1#!@6.!... H 11!@1.!...
7mount recovered in year #D -1.!@#'!...
7mount remaining after year # that needs to be recoveredD -11!@1.!... - -1.!@#'!... H -1!.17!...
9ore than this amount is recovered in year '! so we must calculate the fraction of year ' it takes to
recover the remaining -1!.17!.... It takes ..1#': A-1!.17!... P -;!#'1!...B of a year to recover the
remainder! or 1.6 months. Thus! the total payback for Poofy Puffs is # years and 1.6 months.
%illing %iberD
Capital Budgeting Process and Techniques """
Initial outlayD -1'!6..!...
7mount recovered in year 1D -7!#'.!...
7mount remaining that needs to be recovered after year 1D -1'!6..!... - -7!#'.!... H :!#7.!...
9ore than this amount is recovered in year #! so we must calculate the fraction of year # it takes to
recover the remaining -:!#7.!.... It takes ..77 A:!#7.!... P ;!1..!...B of a year to recover the
remainder! or @.#@ months. Thus! the total payback for %illing %iber is 1 year and @.#1 months.
iscounted Payback Period
$iscounted
Eear Poofy Puffs %illing %iber Poofy Puffs %illing %iber
. -A#1!;@.!...B -A1'!6..!...B
-A#1!;@.!...B -A1'!6..!...B
1 -1#!@6.!... -7!#'.!...
-11!77#!7#7 -:!67#!7#7
# -1.!@#'!... -;!1..!...
-@!.#7!#7' -:!:@1!#16
' -;!#'1!... -;!:#@!...
-:!1;1!.7# -:!1;'!.@6
1 -7!#1#!... -6!#';!@..
-1!@1:!';' -'!67;!#'@
Poofy PuffsD
Initial outlayD -#1!;@.!...
7mount recovered in year 1 in discounted dollarsD -11!77#!7#7
7mount remaining after year 1 that needs to be recoveredD -#1!;@.!... - -11!77#!7#7 H -1'!117!#7'
7mount recovered in year # in discounted dollarsD -@!.#7!#7'
7mount remaining after year # that needs to be recoveredD -1'!117!#7' - -@!.#7!#7' H -1!.@.!...
9ore than this amount is recovered in year '! so we must calculate the fraction of year ' it takes to
recover the remaining -1!.@.!.... It takes ..:: A1!.@.!... P :!1;1!.7#B of a year to recover the
remainder! or 7.@1 months. Thus! the total discounted payback for Poofy Puffs is # years and ; months.
%illing %iberD
Initial outlayD -1'!6..!...
7mount recovered in year 1 in discounted dollarsD -:!67#!7#7
7mount remaining that needs to be recoveredD -1'!6..!... - -:!67#!7#7 H -:!@#7!#7'
7mount recovered in year # in discounted dollarsD -:!:@1!#16
7mount remaining after year # that needs to be recoveredD -:!@#7!#7' - -:!:@1!#16 H -#''!.6;
9ore than this amount is recovered in year '! so we must calculate the fraction of year ' it takes to
recover the remaining -#''!.6;. It takes ...1 A-#''!.6; P :!1;'!.@6B of a year to recover the
remainder! or .1 months. Thus! the total discounted payback for %illing %iber is # years and ..1 months.
!ccounting "ate of "eturn:
Poofy PuffsD
The average book value of Poofy Puffs is -#1!;@.!... P #! or -1#!116!.... The average net income for
the project A-:!7#7!6.. G -1!7..!6.. G -#!..;!6.. G -7!#1#!...B P 1 H -6!1:@!:#6. (e&t! divide the
average net income by the average book value of the project! or A-6!1:@!:#6 P -1#!116!...B H ..1161 or
11.61<.
%illing %iberD
""$ Chapter 7
The average book value is -1'!6..!... P # H -:!76.!... while the average net income is -'!@#1!176! or
A-'!;66!... G -1!7#6!... G -6!#61!... G -1!;:'!@..B P 1 H -'!@#1!176. The project+s accounting rate
of return is 6;.11<! or -'!@#1!176 P -:!76.!....
#et Present $alue:
$iscounted
Eear Poofy Puffs %illing %iber Poofy Puffs %illing %iber
. -#1!;@.!... -1'!6..!...
1 1#!@6.!... 7!#'.!... -11!77#!7#7 -:!67#!7#7
# 1.!@#'!... ;!1..!... -@!.#7!#7' -:!:@1!#16
' ;!#'1!... ;!:#@!... -:!1;1!.7# -:!1;'!.@6
1 7!#1#!... 6!#';!@.. -1!@1:!';' -'!67;!#'@
%um & '()*+(,*-./ '0(*(01*077
Poofy PuffsD (P) H P)inflows F P)outflows H -'1!@'.!16: F -#1!;@.!... H -7!.1.!16:.
%illing %iberD (P) H -#'!'#;!#77 F -1'!6..!... H -@!;#;!#77.
2nternal "ate of "eturn:
( ) ( ) ( ) ( ) r r r r + + + +
+ + + + =
1 1 1 1
1 ' # 1
... ! #1# ! 7 -

... ! #'1 ! ; -

... ! @#' ! 1. -

... ! @6. ! 1# -
. -#1!;@.!.. - -. D Puffs Poofy
r H #1..@<
( ) ( ) ( ) ( ) r r r r + + + +
+ + + + =
1 1 1 1
1 ' # 1
@.. ! #'; ! 6 -

... ! :#@ ! ; -

... ! 1.. ! ; -

... ! #'. ! 7 -
. -1'!6..!.. - -. D %iber %illing
r H 11.61<
Profitability Inde&D
PI H P)inflows P P)outflows
PIPoofy Puffs H -'1!@'.!16: P -#1!;@.!... H 1.#;
PI%illing %iber H -#'!'#;!#77 P -1'!6..!... H 1.7'
7nalysisD The minimum re4uired payback period is 1.76 years! therefore both projects would be
rejected using the payback and discounted payback period. %rom an accounting rate of return A77=B
perspective! both projects would be acceptable as they have 7==s above the re4uired 16<. ?ased on
the (P) method! both projects would be acceptable as the net present values are positive. ?oth projects
are acceptable using the I== method as well! as the I==s are greater than 1.<. 7lso! the profitability
inde& APIB is greater than 1.. for both projects! thus both are acceptable using that criterion. "f course!
since both of these projects are independent and Znormal!+ one would not e&pect the (P)! I== or PI
methods to conflict.
Technically! there is not a scaling issue with these two projects as the (P) method and the I== method
rank %illing %iber as the better project. 3ince the projects are independent! the firm should proceed with
both of them.
Capital Budgeting Process and Techniques ""3