Chapter 6

Answers to Concept Review Questions

2. The total dollar return on the stock you bought for $40 is $6 $4 for the price increase and $2 for the
dividend. The total percentage return is 15%; the dividend yield is 5%, and the capital gain yield is
10%, which sum to the total return of 15%.
3. Investors need to pay attention to both real and nominal returns because, while nominal returns
measure the dollar value increase in an investment, only real returns can measure the increase in
purchasing power the investment represents over time. If investors care about how much they can
buy with the money that they accumulate, then real returns are far more important than nominal
returns. Nominal returns are important as wellfor example, investors pay taxes based on nominal
returns.
5. Table 6.1 shows that sometimes, though not often, an assets nominal return may be higher than its
real return When inflation is positive, the nominal return is always higher than the real return.
However, if prices are falling rather than rising, we have deflation rather than inflation, and real
returns are higher than nominal returns. From Figure 6.2 you can see that there were periods of falling
prices in the early 1920s until the mid 1930s. Notice that starting in 1920 and moving forward, the
slope of the equity line is steeper in Figure 6.3 than it is in Figure 6.2. This illustrates that during
deflation, real returns are higher than nominal returns.
8. A standard deviation halfway between the standard deviation of stocks and bonds would be about
14%. Finding 14% on the horizontal axis of Figure 6.6 and moving up to the trendline, we would
predict an average return for this asset class of about 8.5%.
11. The dots in Figure 6.9 appear to be almost randomly scattered because these dots represent individual
stocks risk. The market should reward riskier investments with higher returns, but only if by the term
riskier we mean systematically riskier. The unsystematic risk of a given investment doesnt
matter because investors can eliminate that risk at virtually no cost by diversifying. Therefore, the
market will not reward investors who choose to bear unsystematic risk unnecessarily. In Figure 6.9,
the vertical axis measures returns and the horizontal axis measures standard deviation. Because
Figure 6.9 is focused on individual stocks rather than on portfolios, the risk measure we are plotting
includes both systematic and unsystematic risk. This clouds the underlying relationship between risk
and return because our horizontal axis is not using a clean risk measure.

Answers to End-of-Chapter Questions

Q6-2. Why do real returns matter more than nominal returns?
A6-2.

If the reason that people invest is to have more money to spend later in life, then the real return
measures the increase in spending power over time. It is not how much money you have that
counts, its how much you can buy with that money.

Q6-4. Explain why dollar returns and percentage returns can sometimes send conflicting signals when
you are comparing two different investments.
A6-4.

If the two investments require the same amount of money up front, this will not usually be a
problem. However, if one investment is much larger than another, then the larger investment can
generate a higher dollar return while the smaller one generates a higher percentage return. For
example, suppose one person invests $100 and earns a total dollar return of $10, while another
1

person invests $50 and earns a total dollar return of $6. Clearly the dollar return is larger on the
first investment, but the percentage return is higher on the second.
Q6-6. Look at Table 6.1. Compare the best and worst years for Tbills in terms of their nominal returns,
and then compare the best and worst years in terms of real returns. Comment on what you find.
A6-6.

The spread between the best and worst years is 14.7% in nominal terms and 34.8% in real terms.
In part this is because the nominal return on Treasury bills has a floor at zero percent, but the
real return can be, and often has been negative. This occurs when the inflation rate is higher than
the nominal interest rate.

Q6-10. Are there diminishing returns to risk taking?

A6-10. No. From Figure 6.6, it appears that the relationship between risk and return is linear. The more
risk you take, the higher return you earn with no sign that the incremental return falls as risk
increases. On the other hand, there are diminishing returns to wealth. That is, an extra $10,000
would mean a lot more to you than it would to a person as wealthy as Bill Gates. So even if the
reward for bearing risk does not diminish, the utility of earning higher returns does diminish.
Q6-12. Look at Figure 6.9. The unlabeled dot on the far right of the graph represents the average return
and standard deviation of Advanced Micro Devices. Down and to the left from that point you can
see the position of American Airlines. Now imagine that you form a portfolio with half of your
money in AMD and half in AMR. Where do you think that portfolio would plot in Figure 6.9? For
a hint, see Figure 6.8.
A6-12. In Figure 6.8 we can see that the standard deviation of a portfolio invested equally in AMD and
AMR has a standard deviation of about 45%. That is less than the standard deviation of either
AMD or AMR. That is the power of diversification. The portfolio is less volatile than either stock
in the portfolio. The average return on AMD is higher than the return on AMR, so the return on a
portfolio would be right in between. If the return on the portfolio is between the returns of the
individual stocks, but the volatility of the portfolio is lower than the volatility of either stock, then
the portfolio would plot in Figure 6.9 up and to the left of the point for American Airlines. This
suggests that investing in the portfolio is clearly better than investing in AMR alone because the
portfolio offers a higher return and lower volatility at the same time.
Q6-13. Classify each of the following events as a source of systematic or unsystematic risk.
a. Alan Greenspan retires as Chairman of the Federal Reserve and Arnold Schwarzenegger is
appointed to take his place.
b. Martha Stewart is convicted of insider trading and is sentenced to prison.
c. An OPEC embargo raises the world market price of oil.
d. A major consumer products firm loses a product liability case.
e. The Supreme Court rules that no employer can layoff an employee without first giving 30
days notice.
A6-13. a, c, and e are systematic risks because they affect most firms in the market. Item b primarily
affects Martha Stewarts company, and likewise, d mainly affects the firm involved in the lawsuit,
so these are unsystematic risks. However, one could argue that the Martha Stewart case has a
systematic component if investors believe that by convicting Martha, the government has
effectively deterred many other insider traders from trading.

Solutions to End-of-Chapter Problems

P6-1.

You purchase 1,000 shares of Spears Grinders Inc. stock for $45 per share. A year later, the stock
pays a dividend of $1.25 per share and it sells for $49.
a. Calculate your total dollar return.
b. Calculate your total percentage return.
c. Do the answers to parts (a) and (b) depend on whether you sell the stock after one year or
continue to hold it?

A6-1.

a. 1,000 ($1.25 + $4) = $5,250

b. ($49 + $1.25 - $45)/$45 = 0.1167 or 11.67%.
c. The answer does not depend on whether you sell the stock or hold it.

P6-3.

D. S. Trucking Company stock pays a $1.50 dividend every year. A year ago the stock sold for
$25 per share, and its total return during the past year was $20%. What does the stock sell for
today?

A6-3.

0.20 = (P + $1.50 - $25)/$25 which implies that P = $28.50.

P6-5.

David Rawlings pays $1,000 to buy a five-year Treasury bond that pays a six percent coupon rate
(for simplicity, assume annual coupon payments). One year later, the markets required return on
this bond has increased from six percent to seven percent. What is Rawlings total return (in dollar
and percentage terms) on the bond?

A6-5.

After one year, the bond price will fall to $966.13. The total dollar return is ($966.13 + $60 $1,000) = $26.13 and the percentage return is 2.613%. To solve for the $966.13 price of the
bond, use the following calculator inputs:
N = 4 (Note that 4 is used, since one year has passed and there are four years remaining in the life
of the bond)
PMT = 60 (6% $1,000)
FV = $1,000
I = 7%
Solve for PV (bond price) = -$966.13

P6-8.

Refer to Figure 6.2. At the end of each line we show the nominal value in 2003 of a $1
investment stocks, bonds, and bills. Calculate the ratio of the 2003 value of $1 invested in stocks
divided by the 2003 value of $1 invested in bonds. Now recalculate this ratio using the real values
in Figure 6.3. What do you find?

A6-8.

In nominal terms, this ratio is 15,579/148 = 105.3, and in real terms, 719/6.8 = 105.7, ratios
which are about the same. The relative performance of stocks vs. bonds (or bills for that matter)
does not depend on whether you measure dollars in nominal or real terms. When we switch from
nominal to real values, we are taking away the effect of inflation on both types of investments.
Because we are simultaneously making the same adjustment to stocks and bonds, their relative
performance does not change.

P6-13. If an investment promises a nominal return of six percent and the inflation rate is one percent,
what is the real return?
3

A6-13. (1.06) = (1.01)(1+x) so x = 0.0495 or 4.95%.

P6-15. The table below shows the average return on U.S. stocks and bonds for 25-year periods ending in
1925, 1950, 1975, and 2000. Calculate the equity risk premium for each quarter century. What
lesson emerges from your calculations?
1925
9.7%
3.5%
?

Stocks
Bonds
Premium

1950
10.2%
4.1%
?

1975
11.4%
2.4%
?

2000
16.2%
10.6%
?

A6-15. The risk premiums in each decade are 6.2%, 6.1%, 9.0%, and 5.6%. The main lesson is that the
observed equity risk premium is not constant through time.
P6-20. Use the data below to calculate the standard deviation of nominal and real Treasury bill returns
from 1972-1982. Do you think that when they purchased T-bills investors expected to earn
negative real returns as often as they did during this period? If not, what happened that took
investors by surprise?
Year
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982

Nominal Return (%)

3.8
6.9
8.0
5.8
5.1
5.1
7.2
10.4
11.2
14.7
10.5

Real Return (%)

0.4
-1.7
-3.7
-1.1
0.3
-1.5
-1.7
-2.6
-1.0
5.3
6.4

A6-20. The standard deviations are 3.3% in nominal terms and 3.2% in real terms. The negative real
return periods are times when actual inflation exceeded expected inflation. Investors had not
anticipated higher inflation and failed to require sufficient compensation for inflation during those
times. Note, though, that the mean of the 11-year period is 0.08, or very close to 0. In other
words, on average, those who invest in T-bills just break even with inflation.
P6-23. The table below shows annual returns on the pharmaceutical leader Merck and chip maker
Advanced Micro Devices. The last column of the table shows the annual return that a portfolio
invested 50% in Merck and 50% in AMD would have earned each year. The portfolios return is
simply a weighted average of the returns of Merck and AMD. An example portfolio return
calculation for 1994 is given at the top of the table.
Year
1994
1995
1996
1997
1998

AMD
40.1%
-33.7%
56.1%
-31.1%
63.4%

Merck
50-50 Portfolio
14.9% 27.5% (0.5 x 40.1% + 0.5 x 14.9%)
76.4%
24.0%
35.5%
41.2%
4

1999
2000
2001
2002
2003
Std.
Dev.

-0.2% -7.4%
-4.5% 41.7%
14.8% -35.9%
-59.3% -1.1%
130.7% -11.2%

a. Plot a graph similar to Figure 6.7 showing the returns on Merck and AMD each year.
b. Fill in the blanks by calculating the 50-50 portfolios return each year from 1995-2003 and
then plot this on the graph you created for part (a). How does the portfolio return compare to
the returns of the individual stocks in the portfolio?
c. Calculate the standard deviation of Merck, AMD, and the portfolio and comment on what you
find.
A6-23 a. The graph appears below. Notice that in many years, Merck has a good year when AMD
stock doesnt do very well, and vice versa.

b. The annual returns on the portfolio, starting in 1994 and going to 2003 are: 27.5%, 21.4%,
40.0%, 2.2%, 52.3%, -3.8%, 18.6%, -10.55%, -30.2%, and 59.75%.
c. The standard deviation of Merck, AMD, and the portfolio are 56.4%, 32.7%, and 28.6%
respectively. The portfolio is less volatile than either stock in the portfolio.

Chapter 7

Answers to Concept Review Questions

1. The difference between an assets expected return and its actual return is that the expected return is a
best guess of what the actual return will be, but of course there is no guarantee that actual returns will
equal expected returns. Expected returns are important because managers and investors must make
decisions in a world of uncertainty. They cannot know for sure what outcomes will occur, but they
need to make educated guesses. So the expected return on an investment is of vital importance.
3. Both beta and expected returns are driven by systematic risk. Standard deviation measures both
systematic and unsystematic risk, and therefore it is unreliably related to returns. Beta focuses only on
a stocks systematic risk, so a positive relationship should hold between betas and returns..
6. The standard deviation of a portfolio is typically less than the average of standard deviation of the
assets in the portfolios because the assets betas tend to counteract one another. Seen another way,
standard deviation reflects both systematic and unsystematic risk factors. When individual stocks are
combined in a portfolio, some of the unsystematic risk disappears, so the portfolios standard
deviation is less than the average of the stocks standard deviations. On the other hand, a stocks beta
measures only its systematic risk. This type of risk does not vanish in a portfolio, so the portfolio beta
equals the average of the stock betas.
7. Three factors that influence a stocks expected return according to the CAPM are the risk-free rate,
the beta, and the market risk premium.
8. A stock with no systematic risk has a beta of zero. From the equation of the Security Market Line, we
see that a stock with a beta of zero has an expected return equal to the risk-free rate. This makes sense
because even if a stock has some unsystematic risk, investors can eliminate all of that through
diversification. Therefore, in a portfolio this stock is essentially risk free.

Answers to End-of-Chapter Questions

Q7-2. The table below shows the expected return and standard deviation for two stocks. Is the pattern
shown in the table possible?
Stock Beta Std. Dev.
#1
1.5
22%
#2
0.9
35%
A7-2. Yes, this is possible. A stock with a high beta might have a higher or lower standard deviation
than a stock with a low beta. The standard deviation is made up of both systematic and
unsystematic risk, whereas beta measures just systematic risk. Stock #1 has a high beta and a
relatively low sigma, but this might simply reflect that most of stock #1s risk is systematic. On
the other hand, stock #2 has a higher variance, but if most of this risk is unsystematic, stock #2
will have a lower beta.
Q7-3. Which type of company do you think will have a higher beta? A fast-food chain or a cruise-ship
firm?
A7-3. Cruises are luxuries, and cruise purchases are probably more sensitive to economic conditions
than are hamburger sales. The cruise operator would have a higher beta in all likelihood.
Q7-7. Stock A has a beta of 1.5, and stock B has a beta of 1.0. Determine whether each of the statements
below is true or false.
a. Stock A must have a higher standard deviation than Stock B.
b. Stock A has a higher expected return than Stock B.
c. The expected return on Stock A is 50 percent higher than the expected return on B.
6

A7-7. a. False. b. True. c. False.

Q7-8. If an asset lies above the security market line, is it overpriced or underpriced?
A7-8. Underpriced. A stock above the SML offers an expected return that is too high given its beta.
Therefore, this stock is a bargain and is underpriced. Investors will flock to buy it, driving up its
price and pushing its expected return down to the SML.
Q7-9. A stock has a beta equal to 1.0. Is the standard deviation of the stock equal to the standard
deviation of the market?
A7-9. No. The stock may have a high (low) degree of diversifiable risk, which is part of its standard
deviation, but not part of its beta. Because the stock has both systematic and unsystematic risk,
and because its systematic risk is equal to that of the market (which has only systematic risk), the
stocks standard deviation will probably be greater than that of that market.

Solutions to End-of-Chapter Problems

P7-2. The table below shows the difference in returns between stocks and Treasury bills and the
difference between stocks and Treasury bonds at 10-year intervals.
1964-73
1974-83
1984-93
1994-2003

Stocks vs. Bonds

3.7%
0.2%
7.5%
4.8%

Stocks vs. Bills

8.3%
8.6%
5.4%
2.1%

a. At the end of 1973, the yield on Treasury bonds was 6.6% and the yield on T-bills was 7.2%.
Using these figures and the historical data above from 1964-1973, construct two estimates of
the expected return on equities as of December 1973.
b. At the end of 1983, the yield on Treasury bonds was 6.6% and the yield on T-bills was 7.2%.
Using these figures and the historical data above from 1974-1983, construct two estimates of
the expected return on equities as of December 1983.
c. At the end of 1993, the yield on Treasury bonds was 6.6% and the yield on T-bills was 2.8%.
Using these figures and the historical data above from 1984-1993, construct two estimates of
the expected return on equities as of December 1993.
d. At the end of 2003, the yield on Treasury bonds was 5.0% and the yield on T-bills was 1.0%.
Using these figures and the historical data above from 1994-2003, construct two estimates of
the expected return on equities as of December 2003.
e. What lessons do you learn from this exercise? How much do your estimates of the expected
return on equities vary over time, and why do they vary?
A7-2. a. Using T bonds, expected return on stocks was 6.6% + 3.7% = 10.3%. Using T bills, it was
7.2% + 8.3% = 15.5%.
b. Using T bonds, expected return on stocks was 6.6% + .2% = 6.8%. Using T bills, it was 7.2%
+ 8.6% = 15.8%
c. Using T bonds, expected return on stocks was 6.6% + 7.5% = 14.1%. Using T bills, it was
2.8% + 5.4% = 8.2%.

d. Using T bonds, expected return on stocks was 5% + 4.8% = 9.8%. Using T bills, it was 1% +
2.1% = 3.1%.
e. This shows that the risk premium on stocks is very variable over time. Returns depend on
how stocks are performing and on interest rates. Ten years is probably not a long enough
period on which to compute a long-term market risk premium
P7-3.

Use the information below to estimate the expected return on the stock of W.M. Hung
Corporation.
Long-run average stock return = 10%
Long-run average T-bill return = 4%
Current T-bill return = 2%
A7-3. The long-run risk premium on the stock is 6%, so add the current T-bill rate, 2%, to get Hungs
expected return, 8%.
P7-4.

Calculate the expected return, variance, and standard deviation for the stocks in the table below.

Product Demand Probability Stock #1

Stock #2
Stock #3
High
20%
30%
20%
15%
Medium
60%
12%
14%
10%
Low
20%
-10%
-5%
-2%
A7-4. Expected returns are: Stock 1 (11.2%); Stock 2 (11.4%); Stock 3 (8.6%)
Variances are: Stock 1 (160.96); Stock 2 (69.9); Stock 3 (31.1)
Standard deviations are: Stock 1 (12.7%); Stock 2 (8.4%); Stock 3 (5.6%)
P7-6.

Refer to Figure 7.2 and answer the following questions.

a. What return would you expect on a stock with a beta of 2.0?
b. What return would you expect on a stock with a beta of 0.66?
c. What determines the slope of the line in Figure 7.2?
A7-6. a. Beta = 2, return = 16%
b. Beta = 0.66, return = 8%
c. The slope is the market risk premium. Rm Rf = 10-4 = 6%
P7-12. Calculate the expected return of the portfolio described in the accompanying table.
Stock
$ Invested
Expected Return
A
$40,000
10%
B
$20,000
14%
C
$25,000
12%
A7-12. Expected return: 40,000/85,000 10% + 20,000/85,000 14% + 25,000/85,000 12% =
11.53%
P7-18. Petro-Chem Inc. stock has a beta equal to 0.9. Digi-Media Corp.s stock beta is 2.0. What is the
beta of a portfolio invested equally in these two stocks?
A7-18. Portfolio beta = 0.5 0.9 + 0.5 2 = 1.45
P7-19. The risk-free rate is currently 5%, and the expected risk premium on the market portfolio is 7%.
What is the expected return on a stock with a beta of 1.2?
A7-19. R = Rf + B(Rm Rf)
= 5 + 1.2 7
= 13.4%

P7-20. The expected return on the market portfolio equals 12%. The current risk-free rate is 6%. What
is the expected return on a stock with a beta of 0.66?
A7-20. R = Rf + B(Rm Rf)
= 6 + 0.66 (12-6)
= 9.96%
P7-21. The expected return on a particular stock is 14%. The stocks beta is 1.5. What is the risk-free
rate if the expected return on the market portfolio equals 10%.
A7-21. R = Rf + B(Rm Rf)
14 = Rf + 1.5 x (10 Rf)
14 = Rf + 15 1.5Rf
Rf = 2
P7-24. A particular stock sells for $30. The stocks beta is 1.25, the risk-free rate is 4%, and the expected
return on the market portfolio is 10%. If you forecast that the stock will be worth $33 next year
(assume no dividends), should you buy the stock or not?
A7-24. R = Rf + (Rm Rf) x Beta
= 4 + 1.25 (10 4) = 11.5%
Return on the stock: (33-30)/30 = 10%.
Dont buy the stock. You expect a return of 10%. The stock should return 11.5%, according to
CAPM.

Chapter 8
Answers to Concept Review Questions
1. Other things being equal, managers would prefer (1) an easily applied capital budgeting technique
that (2) considers cash flow, (3) recognizes the time value of money, (4) fully accounts for expected
risk and return, and (5) when applied, leads to higher stock prices.
4. Payback is popular because it is very easy to compute and to understand and because it gives
managers a rough measure of how soon they will receive intermediate cash flows from a project that
they could potentially invest in other projects. It would be used primarily in situations that feature
quick turnover of projects.
5. The major flaws of the payback and discounted payback methods are that payback method does not
take the time value of money into account and they both ignore cash flows beyond the payback
period.
8. IRR and NPV are related in that both use the time value of money and take risk into account. NPV
accounts for risk by using a risk-adjusted discount rate, while IRR uses a risk-adjusted hurdle rate
against which to compare the project and make the accept/reject decision.
10. You will recall that the scale problem indicates that we should use practical sense along with IRR
analysis: we should choose the investment that offers the best ABSOLUTE payoff to maximize
shareholder wealth, regardless of its percentage payoff. The timing problem has to do with
managers inability or unwillingness to look at the longer term and simply look for the next best fix
short term payoffs rather than visionary projects that involve R&D and the like. The firm can use
IRR with mutually exclusive projects by subtracting one set of cash flows from the other and finding
the IRR of the project that represents these differential cash flows. If the differential project has
9

conventional cash flows, then accept the project on top if the IRR exceeds the hurdle rate. If the
differential project has non-conventional cash flows, then accept the project on the top of the
subtraction if the hurdle rate exceeds the IRR.
11. NPV, IRR, and PI capital budgeting approaches are related because they adjust for the time value of
money and risk. Again, for a single project with conventional cash flows, all three methods will
provide the same accept/reject decision..
12. Choosing a project with the highest PI may not be the same as accepting a project with the highest
dollar NPV. To maximize shareholder wealth, a manager wants to add the most possible risk-adjusted
(positive NPV) dollars to the company. But while NPV is the best measure to use, it also demands a
certainty in measuring variables that few, if any, firms can provide. PI and IRR are both substitutes
for NPV, but they are only estimatesthey are not exact measures.

Answers to End-of-Chapter Questions

Q8-2. In statistics, you learn about Type I and Type II errors. A Type I error occurs when a statistical test
rejects a hypothesis when the hypothesis is actually true. A Type II error occurs when a test fails
to reject a hypothesis that is actually false. We can apply this type of thinking to capital
budgeting. A Type I error occurs when a firm rejects an investment project that would actually
enhance shareholder wealth. A Type II error occurs when a firm accepts a value-decreasing
investment, an investment it should have rejected.
a. Describe the features of the payback rule that could lead to Type I errors.
b. Describe the features of the payback rule that could lead to Type II errors.
c. Which error do you think is more likely to occur when firms use payback analysis? Does
your answer depend on the length of the cutoff payback period? You can assume a typical
project cash flow stream, meaning that most cash outflows occur in the early years of a
project.
A8-2. a. Payback could lead to Type 1 errors when it rejects a good project that has large cash flows
after the payback period cutoff.
b. Type II errors occur when payback says to accept a project that doesn't return enough to
compensate for the risk taken.
c. A type I error is more likely good project with higher cash flows in later years may be
rejected.
Q8-7. In what way is the NPV consistent with the principle of shareholder wealth maximization? What
happens to the value of a firm if a positive-NPV project is accepted? If a negative-NPV project is
accepted?
A8-7. The NPV approach is consistent with shareholder maximization because it suggests that firms
should only accept projects which earn returns above the opportunity costs of the firms investors.
The NPV in effect measures the dollar contribution that the given project is expected to make to
the firms overall value. If a firm invests in a project with NPV > $0, then the share price will
rise. Conversely, a firms share price will fall if it invests in projects with NPV < $0.
Q8-8. A particular firms shareholders demand a 15 percent return on their investment, given the firms
risk. However, this firm has historically generated returns in excess of shareholder expectations,
with an average return on its portfolio of investments of 25 percent.
a. Looking back, what kind of stock-price performance would you expect to see for this firm?
b. A new investment opportunity arises, and the firms financial analysts estimate that the
projects return will be 18 percent. The CEO wants to reject the project because it would

10

lower the firms average return and therefore lower the firms stock price. How do you
respond?
A8-8. a. A firm that consistently earns returns higher than its opportunity cost of capital is adding
value to the firm, and its stock price should increase.
b. For the project returning 18%, 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.
Q8-9. What are the potential faults in using the IRR as a capital budgeting technique? Given these
faults, why is this technique so popular among corporate managers?
A8-9. The IRR suffers from several problems. The IRR is not well suited to ranking projects with very
different scales or projects with very different cash flow timing patterns. The IRR method can
also yield no solution or multiple solutions that are hard to interpret. Despite the flaws, the IRR
method enjoys widespread use because in most investment situations it generates reliable
accept/reject recommendations and it is easy to interpret intuitively.
Q8-10. Why is the NPV considered to be theoretically superior to all other capital budgeting techniques?
Reconcile this result with the prevalence of the use of IRR in practice. How would you respond to
your CFO if she instructed you to use the IRR technique to make capital budgeting decisions on
projects with cash flow streams that alternate between inflows and outflows?
A8-10. The NPV is the most appropriate capital budgeting method because it yields correct accept/reject
situations and correct project rankings. Nevertheless, it is somewhat less intuitive than the IRR.
In projects with cash flow stream that switch signs, the IRR 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
IRR.
Q8-11. Outline the differences between NPV, IRR, and PI. What are the advantages and disadvantages of
each technique? Do they agree with regard to simple accept or reject decisions?
A8-11. The NPV is calculated by discounting all of a projects cash flows to the present. The IRR is
calculated by finding the discount rate which equates the NPV to zero. The profitability index is
the ratio of the present value of a projects cash flows (excluding the initial cash outflow) divided
by the initial cash outflow. All three methods lead to the same accept/reject decision when
evaluating a single project, but IRR and PI have problems when ranking projects. NPV generally
overcomes these problems.
Q8-12. Under what circumstances will the NPV, IRR, and PI techniques provide different capital
budgeting decisions? What are the underlying causes of the differences often found in the ranking
of mutually exclusive projects using NPV and IRR?
A8-12. IRR, NPV, and PI can lead to different decisions when they are used to rank projects or to select
between mutually exclusive projects. IRR and PI methods are not well suited to evaluating
projects which vary in scale. The NPV method yields correct project rankings no matter what the
scale of the project.

Solutions to End-of-Chapter Problems

P8-3.

The cash flows associated with three different projects are as follows:
Cash Flows

Alpha
($ in millions)
11

Beta
($ in millions)

Gamma
($ in millions)

Initial Outflow
Year 1
Year 2
Year 3
Year 4
Year 5

- 1.5
0.3
0.5
0.5
0.4
0.3

- 0.4
0.1
0.2
0.2
0.1
- 0.2

- 7.5
2.0
3.0
2.0
1.5
5.5

a. Calculate the payback period of each investment.

b. Which investments does the firm accept if the cutoff payback period is three years? Four
years?
c. If the firm invests by choosing projects with the shortest payback period, which project
would it invest in?
d. If the firm uses discounted payback with a 15 percent discount rate and a 4-year cutoff
period, which projects will it accept?
e. One of these almost certainly should be rejected, but might be accepted if the firm uses
payback analysis. Which one?
f. One of these projects almost certainly should be accepted (unless the firms opportunity cost
of capital is very high), but might be rejected if the firm uses payback analysis. Which one?
A8-3. a. Payback of Alpha = 3.5 years, payback of Beta = 2.5 years, payback of Gamma = 3.3 years
b. If the cutoff is 3 years, then only Beta is acceptable. If the cutoff is 4 years, then all of the
projects are acceptable.
c. Project Beta because its payback of 2.5 years is the shortest.
d. If the firm uses discounted payback with a cutoff of 4 years, then Alpha will payback in about
5 years, Beta in just under 4 years and Gamma in just over 4 years. This means only Beta is
acceptable.
e. Project Beta should be rejected. You must pay out a total of .6 million and take in .6 million.
When 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 Gamma is rejected under payback, but even without discounting, seems to have a
high dollar return for the investment. You pay $7.5 million and receive a total of $14 million
in cash inflows. Unless the firm has a very high discount rate, greatly lowering the value of
the last $5.5 million cash flow, this is likely to be an attractive investment.
P8-4.

Calculate the net present value (NPV) for the following 20-year projects. Comment on the
acceptability of each. Assume that the firm has an opportunity cost of 14 percent.
a. Initial cash outlay is $15,000; cash inflows are $13,000 per year.
b. Initial cash outlay is $32,000; cash inflows are $4,000 per year.
c. Initial cash outlay is $50,000; cash inflows are $8,500 per year.

A8-4.

a. Project A has CFo = $-15,000, and 20 inflows of $13,000. At a 14% discount rate, its NPV is
$71,100.70. This is positive NPV and an acceptable project.
b. Project B has CFo = -$32,000 and 20 inflows of $4,000. At 14%, its NPV is -$5507.47. This
is negative NPV and is not acceptable.
c. Project C has CFo = -$50,000, and 20 inflows of $8,500. At a 14% discount rate, its NPV is
$6,296.61. This is positive NPV and an acceptable project

P8-7.

Scotty Manufacturing is considering the replacement of one of its machine tools. Three
alternative replacement toolsA, B, and Care under consideration. The cash flows associated
with each are shown in the following table. The firms cost of capital is 15 percent.
A
B
C
12

Initial cash
outflow (CFo)
Year (t)
1
2
3
4
5
6
7
8

$95,000
$20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000

$50,000
Cash Inflows (CFt)
$10,000
12,000
13,000
15,000
17,000
21,000
-

$150,000
$58,000
35,000
23,000
23,000
23,000
35,000
46,000
58,000

a. Calculate the NPV of each alternative.

b. Using NPV, evaluate the acceptability of each tool.
c. Rank the tools from best to worst, using NPV.
A8-7. Project
A
B
C

NPV
-$5,253.57
$2,424.27
$17,992.95

Decision
Reject
Accept
Accept

Project C is the best, followed by Project B. Project A is the worst project, and is unacceptable.
P8-8.

Erwin Enterprises has 10 million shares outstanding with a current market price of $10 per share.
There is one investment available to Erwin, and its cash flows are provided below. Erwin has a
cost of capital of 10 percent. Given this information, determine the impact on Erwins stock price
and firm value if capital markets fully reflect the value of undertaking the project.
Initial cash outflow = $10,000,000
Year Cash Inflow
1
$3,000,000
2
$4,000,000
3
$5,000,000
4
$6,000,000
5
$9,800,000

A8-8. NPV of project = $9,972,742

Current firm value = $10 $10,000,000 = $100,000,000
New firm value = $100,000,000 + $9,972,742 = $109,972,742
New stock price = $109,972,742 $10,000,000 = $11.00 per share
P8-11. Contract Manufacturing, Inc., is considering two alternative investment proposals. The first
proposal calls for a major renovation of the companys manufacturing facility. The second
involves replacing just a few obsolete pieces of equipment in the facility. The company will
choose one project or the other this year, but it will not do both. The cash flows associated with
each project appear below, and the firm discounts project cash flows at 15 percent.
Year
0
1
2
3

Renovate
Replace
$9,000,000 $1,000,000
3,500,000
600,000
3,000,000
500,000
3,000,000
400,000
13

4
5

2,800,000
2,500,000

300,000
200,000

a. Rank these investments based on their NPVs.

b. Rank these investments based on their IRRs.
c. Why do these rankings yield mixed signals?
A8-11. Project
Renovate
Replace

NPV
$1,128,309
$433,779

IRR
20.5%
36%

The Renovate project has a higher NPV but the Replace project has a higher IRR.
a. Ranking on NPV: A, B
b. Ranking on IRR: B, A
c. The rankings provide mixed signals because of the differing 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 IRRs, as is the case with the
Replace project.
P8-13. A certain project has the following stream of cash flows:
Year
0
1
2
3
4

Cash Flow
$ 17,500
-80,500
138,425
-105,455
30,030

a. Fill in the following table:

Cost
ofCapital(%)
0
5
10
15
20
25
30
35
50

Project
NPV
______
______
______
______
______
______
______
______
______

b. Use the values developed in part a to draw a NPV profile for the project.
c. What is this projects IRR?
d. Describe the conditions under which the firm should accept this project.
A8-13.
a. Cost of
Capital
0
5
10

Project
NPV
0
-1.35
0
14

15
20
25
30
35
50

.56
0
-.672
0
3.46
41.48

c. The project has an IRR at every point where it crosses the discount rate axis, in this case at
0%, 10%, 20% and 30%.
d. This project is acceptable at discount rates greater than 30%, when the NPV is positive.
b.
Project NPV
50
40
30
20

Project NPV

10
0
-10

10

P8-15. You have a $10 million capital budget and must make the decision about which investments your
firm should accept for the coming year. Use the following information on three mutually
exclusive projects to determine which investment your firm should accept. The firms cost of
capital is 12 percent.
Project 1
Project 2
Project 3
Initial cash outflow
-$4,000,000
-$5,000,000
-$10,000,000
Year 1 cash inflow
1,000,000
2,000,000
4,000,000
Year 2 cash inflow
2,000,000
3,000,000
6,000,000
Year 3 cash inflow
3,000,000
3,000,000
5,000,000
a. Which project do you accept on the basis of NPV?
b. Which project do you accept on the basis of PI?
c. If these are the only investments available, which one do you select?
A8-15. a.

NPV1 = -$4,000,000 + $1,000,000 (1.12)-1 + $2,000,000 (1.12)-2 + $3,000,000 (1.12)-3

= $622,586
NPV2 = -$5,000,000 + $2,000,000 (1.12)-1 + $3,000,000 (1.12)-2 + $3,000,000 (1.12)-3
= $1,312,637
NPV3 = -$10,000,000 + $ 4,000,000 (1.12)-1 +$ 6,000,000 (1.12)-2 + $5,000,000 (1.12)-3
= $1,913,493 [highest NPV]

b. PI1 = $4,622,586 / $4,000,000 = 1.16

PI2 = $6,312,637 / $5,000,000 = 1.26 [highest PI]
PI3 = $11,913,493 / $10,000,000 = 1.19

15

c. Although Project #2 provides more bangs for the buck as represented by its higher PI,
Project #3 should be accepted since it has the higher NPV and there are no other investments
under consideration.
P8-17. Butler Products has prepared the following estimates for an investment it is considering. The
initial cash outflow is $20,000, and the project is expected to yield cash inflows of $4,400 per
year for seven years. The firm has a 10 percent cost of capital.
a. Determine the NPV for the project.
b. Determine the IRR for the project.
c. Would you recommend that the firm accept or reject the project? Explain your answer.
A8-17. Year
0
Cash Flow -$20,000

1
4,400

2
4,400

3
4,400

4
4,400

5
4,400

6
4,400

7
4,400

a. At 10%, the NPV of the project is $1,421.04.

b. The IRR is 12.13%
c. This project is acceptable by both NPV and IRR criteria. It has a positive NPV and its IRR is
greater than its hurdle rate of 10%.
P8-20. Wilkes, Inc., must invest in a pollution-control program in order to meet federal regulations to
stay in business. There are two programs available to Wilkes: an all-at-once program that will be
immediately funded and implemented and a gradual program that will be phased in over the next
three years. The immediate program costs $5 million, whereas the phase-in program will cost $1
million today and $2 million per year for the following three years. If the cost of capital for
Wilkes is 15 percent, which pollution-control program should Wilkes select?
A8-20. Year All at Once
Gradual
0
-$5
-$1
1
-$2
2
-$2
3
-$2
The NPV of the All at once project is -$5 million. The NPV of the Gradual project, at a discount
rate of 15%, is -$5.57. It is cheaper to implement the all at once pollution control project.

16