Selected Solution to Chapter 9 : Net present value and other investment criteria

Q13 NPV versus IRR Consider the following two mutually exclusive projects:

Year Cash Flow (X) Cash Flow (Y)

0 -4,000 -4,000
1 2,500 1,500
2 500 2,000
3 1,800 2,600

Sketch the NPV profiles for X and Y over a range of discount rates from zero to 25 percent.
What is the crossover rate for these two projects?

Period 0 1 2 3
CF (X) -$4,000 2,500 500 1,800
CF (Y) -$4,000 1,500 2,000 2,600

cash flow1 cash flow2 cash flow3

NPV = cash flow0 2
(1 + r) (1 + r) (1 + r)3

2,500 500 1,800

NPV (X) = -$4,000
(1 + r) (1 + r)2 (1 + r)3

1,500 2,000 2,600

NPV (Y) = -$4,000
(1 + r) (1 + r)2 (1 + r)3

r(%) 0 1% 2% 3% 4% 5% 6%
NPV (X) 800 705 615 530 448 371 297
NPV (Y) 2,100 1,950 1,807 1,671 1,541 1,418 1,300

r(%) 7% 8% 9% 10% 11% 12% 13%

NPV (X) 227 160 96 35 -23 -79 -131
NPV (Y) 1,188 1,081 979 882 789 700 616

r(%) 14% 15% 16% 17% 18% 19% 20%

NPV (X) -182 -230 -276 -320 -362 -402 -440
NPV (Y) 535 458 384 313 246 181 120

r(%) 21% 22% 23% 24% 25% 91.73%

NPV (X) -476 -511 -544 -576 -607 -1,202
NPV (Y) 61 4 -50 -102 -151 -1,202

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 21% 22% 23% 24% 25%
2,500

2,000 NPV (X)

NPV (Y)
1,500

1,000

500

-500

-1,000
Selected Solution to Chapter 9 : Net present value and other investment criteria

Q17
a. PBA = 3 + ($110K/$380K) = 3.29 years;
PBB = 2 + ($2K/$10K) = 2.20 years
Payback criterion implies accepting project B, because it pays back sooner than project A.

b. A: $10K/1.15 + $25K/1.152 + $25K/1.153 = $44,037.15;

$380K/1.154 = $217,266.23
Discounted payback = 3 + ($170,000 – 44,037.15)/$217,266.23 = 3.58 years
B: $10K/1.15 + $6K/1.152 = $13,232.51;
$10K/1.153 = $6,575.16
Discounted payback = 2 + ($18,000 – 13,232.51)/$6,575.16 = 2.73 years
Discounted payback criterion implies accepting project B because it pays back sooner than A

c. A: NPV = – $170K + $10K/1.15 + $25K/1.152 + $25K/1.153 + $380K/1.154 = $91,303.38

B: NPV = – $18K + $10K/1.15 + $6K/1.152 + $10K/1.153 + $8K/1.154 = $6,381.70
NPV criterion implies accept project A because project A has a higher NPV than project B.

d. A: $170K = $10K/(1+IRR) + $25K/(1+IRR)2 + $25K/(1+IRR)3 + $380K/(1+IRR)4

IRR = 29.34%
B: $18K = $10K/(1+IRR) + $6K/(1+IRR)2 + $10K/(1+IRR)3 + $8K/(1+IRR)4;
IRR = 32.01%
IRR decision rule implies accept project B because IRR for B is greater than IRR for A.

e. A: PI = [$10K/1.15 + $25K/1.152 + $25K/1.153 + $380K/1.154] / $170K = 1.537

B: PI = [$10K/1.15 + $6K/1.152 + $10K/1.153 + $8K/1.154] / $18K = 1.355
Profitability index criterion implies accept project A because its PI is greater than project B’s.

f. In this instance, the NPV and PI criterion imply that you should accept project A, while payback
period, discounted payback and IRR imply that you should accept project B. The final decision
should be based on the NPV since it does not have the ranking problem associated with the other
capital budgeting techniques. Therefore, you should accept project A.

Q23

a. PV of cash inflows = C1/(r – g) = $40,000/(.14 – .07) = $571,428.57 > 0

NPV of the project = –$650,000 + $571,428.57 = –$78,571.43 < 0
so don't start the cemetery business.

b. $40,000/(.14 – g) = $650,000; g = 7.85%

Selected Solution to Chapter 10 : Making caital investment decisions

Q15 Project Evaluation Your firm is contemplating the purchase of a new $750,000 computer-based
order entry system. The system will be depreciated straight-line to zero over its five-year life. It
will be worth $80,000 at the end of that time. You will save $310,000 before taxes per year in
order processing costs and you will be able to reduce working capital by $125,000 (this is a one-
time reduction). If the tax rate is 35 percent, what is the IRR for this project?

Year 0 1 2 3 4 5
(i) Investment
New system -750,000
Reduced NWC 125,000
Salvage of new system 80,000
tax on sale of salvage (35%) 28,000
After-tax sale of salvage 52,000
Net Investment -625,000 160,000

(ii) Operation
Saved costs 310,000 310,000 310,000 310,000 310,000
Depreciation 150,000 150,000 150,000 150,000 150,000
EBIT 160,000 160,000 160,000 160,000 160,000
tax (35%) 56,000 56,000 56,000 56,000 56,000
Net Income 104,000 104,000 104,000 104,000 104,000
+ plus non-cash expense 150,000 150,000 150,000 150,000 150,000
Operating Cash Flow 254,000 254,000 254,000 254,000 254,000

(iii) Project CF -625,000 254,000 254,000 254,000 254,000 414,000

254,000 254,000 254,000 254,000 414,000

NPV = 0 = -625,000
( 1 + r) ( 1 + r)2 ( 1 + r)3 ( 1 + r)4 ( 1 + r)5

solve for r (or IRR) which makes the above statement valid

IRR or r = 32.8522% (in Excel type formula "=IRR(values,[guess])

Selected Solution to Chapter 10 : Making caital investment decisions

Q16 Project Evaluation In the previous problem, suppose your required return on the project is 20
percent and your pretax cost savings are only $300,000 per year. Will you accept the project?
What if the pretax cost savings are only $200,000 per year? At what level of pretax cost savings
would you be indifferent between accepting the project and not accepting it?

Year 0 1 2 3 4 5
(i) Net Investment -625,000 160,000
(ii) Operation
Saved costs 300,000 300,000 300,000 300,000 300,000
Depreciation 150,000 150,000 150,000 150,000 150,000
EBIT 150,000 150,000 150,000 150,000 150,000
tax (35%) 52,500 52,500 52,500 52,500 52,500
Net Income 97,500 97,500 97,500 97,500 97,500
+ plus non-cash expense 150,000 150,000 150,000 150,000 150,000
Operating Cash Flow 247,500 247,500 247,500 247,500 247,500

(iii) Project CF -625,000 247,500 247,500 247,500 247,500 407,500

247,500 247,500 247,500 247,500 407,500

NPV = -625,000 2 3 4
( 1 + 0.2) ( 1 + 0.2) ( 1 + 0.2) ( 1 + 0.2) ( 1 + 0.2)5

NPV = 149,564 Accept project because NPV is greater than zero.

OCF OCF OCF OCF OCF 160,000

NPV = -625,000
( 1 + 0.2) ( 1 + 0.2)2 ( 1 + 0.2)3 ( 1 + 0.2)4 ( 1 + 0.2)5 ( 1 + 0.2)5

NPV = 0 = -625,000 + OCF (PVIFA5, 20%) + 160,000 (PVIF5, 20%)

0= -625,000 + OCF (2.9906) + 160,000 (0.4019)

0= -625,000 + 2.9906(OCF) + 64,304

560,696
OCF =
2.9906

OCF = 187,486

OCF = Saved cost - depreciation - tax + non cash expense

Saved cost = OCF - non cash + tax + depreciation

= 187,486 - 150,000 + 0.35[(187,486 - 150,000)/0.65] + 150,000

= 207,671 is the level of pretax savings that we'd be indifferent whether to

accept the project
Selected Solution to Chapter 10 : Making caital investment decisions

Q23 Calculating a Bid Price Consider a project to supply 60 million postage stamps per year to the U.S.
Postal Service for the next five years. You have an idle parcel of land available that cost $750,000
five years ago; if the land were sold today, it would net you $900,000. You will need to install $2.4
million in new manufacturing plant and equipment to actually produce the stamps; this plant and
equipment will be depreciated straight-line to zero over the project’s five-year life. The
equipment can be sold for $400,000 at the end of the project. You will also need $600,000 in
initial net working capital for the project, and an additional investment of $50,000 in every year
thereafter. Your production costs are 0.6 cents per stamp, and you have fixed costs of $600,000
per year. If your tax rate is 34 percent and your required return on this project is 15 percent, what
bid price should you submit on the contract?

Year 0 1 2 3 4 5
(i) Investment
Land -900,000 900,000
new plant -2,400,000
Salvage of new plang 400,000
tax on sale of salvage (34%) 136,000
After-tax sale of salvage 264,000
NWC -600,000 -50,000 -50,000 -50,000 -50,000 800,000
Net Investment -3,900,000 -50,000 -50,000 -50,000 -50,000 1,964,000

(ii) Operation
Postage stamps sold 60,000,000 60,000,000 60,000,000 60,000,000 60,000,000
Bid price per stamp S S S S S
Total revenue 60,000,000S 60,000,000S 60,000,000S 60,000,000S 60,000,000S
variable cost per stamp 0.6 0.6 0.6 0.6 0.6
Total variable cost 36,000,000 36,000,000 36,000,000 36,000,000 36,000,000
Fixed cost 600,000 600,000 600,000 600,000 600,000
Depreciation 480,000 480,000 480,000 480,000 480,000
EBIT … … … … …
tax (34%) … … … … …
Net Income … … … … …
+ plus non-cash expense 480,000 480,000 480,000 480,000 480,000
Operating cash flow OCF OCF OCF OCF OCF

(iii) Project CF -3,900,000 OCF - 50,000 OCF - 50,000 OCF - 50,000 OCF - 50,000 OCF + 1,964,000

solve for minimum OCF which makes NPV = 0

NPV = 0 = -3,900,000 + OCF (PVIFA5, 15%) - 50,000(PVIFA4, 15%) + 1,964,000(PVIF5, 15%)

0= -3,900,000 + OCF (3.3522) - 50,000(2.8550) + 1,964,000(0.4972)

0= -3,900,000 + 3.3522(OCF) - 142,750 + 976,501

3,900,000 + 142,750 - 976,501

OCF =
3.3522

OCF = 914,698

Net Income = OCF - non cash expense

Net Income = 914,698 - 480000
= 434,698
EBIT = Net income / (1- tax rate)
= 658,633
Total revenue = EBIT + Total cost
= 658633 + 480,000 + 600,000 + 36,000,000 = 37,738,633
Min. Bid per stamp = Total revenue / unit sold
= 0.6289772
Selected Solution to Chapter 11 : Project analysis and Evaluation

Q19 Project Analysis You are considering a new product launch. The project will cost $680,000, have a four-year life, and have no
salvage value; depreciation is straight-line to zero. Sales are projected at 160 units per year; price per unit will be $19,000, variable
cost per unit will be $14,000, and fixed costs will be $150,000 per year. The required return on the project is 15 percent, and the
relevant tax rate is 35 percent.

Base case Year 0 1 2 3 4

(i) Investment
project cost -680,000
(ii) Operation
Unit sold 160 160 160 160
price per unit 19,000 19,000 19,000 19,000
Total revenue 3,040,000 3,040,000 3,040,000 3,040,000
variable cost per unit 14,000 14,000 14,000 14,000
Total variable cost 2,240,000 2,240,000 2,240,000 2,240,000
Fixed cost 150,000 150,000 150,000 150,000
Depreciation 170,000 170,000 170,000 170,000
EBIT 480,000 480,000 480,000 480,000
tax (35%) 168,000 168,000 168,000 168,000
Net Income 312,000 312,000 312,000 312,000
+ plus non-cash expense 170,000 170,000 170,000 170,000
Operating cash flow 482,000 482,000 482,000 482,000

(iii) Project CF -680,000 482,000 482,000 482,000 482,000

482,000 482,000 482,000 482,000

NPV = -680,000
( 1 + 0.15) ( 1 + 0.15)2 ( 1 + 0.15)3 ( 1 + 0.15)4

NPV = 605,303.97

a. Based on your experience, you think the unit sales, variable cost, and fixed cost projections given
here are probably accurate to within ±10 percent. What are the upper and lower bounds for these
projections? What is the basecase NPV? What are the best-case and worst-case scenarios?

Normal Upper bound Lower bound

+ 10% - 10%
Unit sales 160 176 144
Variable cost 14,000 15,400 12,600
Fixed cost 150,000 165,000 135,000

Scenario Base case Worse case Best case

Unit sales 160 144 176
Variable cost 14,000 15,400 12,600
Fixed cost 150,000 165,000 135,000

Base case Worse case Best case

price per unit 19,000 19,000 19,000
Total revenue 3,040,000 2,736,000 3,344,000
Total variable cost 2,240,000 2,217,600 2,217,600
Fixed cost 150,000 165,000 135,000
Depreciation 170,000 170,000 170,000
EBIT 480,000 183,400 821,400
tax (35%) 168,000 64,190 287,490
Net Income 312,000 119,210 533,910
+ plus non-cash expense 170,000 170,000 170,000
Operating cash flow 482,000 289,210 703,910
Require return 15.0% 15.0% 15.0%
NPV 605,304.0 126,685.5 1,156,215.5
Selected Solution to Chapter 11 : Project analysis and Evaluation

b. Evaluate the sensitivity of your base-case NPV to changes in fixed costs.

Base case Fixed cost Fixed cost

increase 10% decrease 10%
Total revenue 3,040,000 3,040,000 3,040,000
Total variable cost 2,240,000 2,240,000 2,240,000
Fixed cost 150,000 165,000 135,000
Depreciation 170,000 170,000 170,000
EBIT 480,000 465,000 495,000
tax (35%) 168,000 162,750 173,250
Net Income 312,000 302,250 321,750
+ plus non-cash expense 170,000 170,000 170,000
Operating cash flow 482,000 472,250 491,750
Require return 15.0% 15.0% 15.0%
NPV 605,304.0 581,098.7 629,509.2
Δ NPV (%) -4.00% 8.33%

c. What is the cash break-even level of output for this project (ignoring taxes)?

Fixed cost
Cash Break even =
(Price - Variable cost)

150,000
=
(19,000 - 14,000)

= 30 units
= 570,000 sales volume

d. What is the accounting break-even level of output for this project? What is the degree of
operating leverage at the accounting break-even point? How do you interpret this number?

Fixed cost + depreciation

Accounting Break even =
(Price - Variable cost)

320,000
=
(19,000 - 14,000)

= 64 units
= 1,216,000 sales volume

DOL = 1 + (FC / OCF)

1 + (150,000 / 170,000)
1.882
DOL can be intrepreted that 1% change in Q (unit sales) will result in 1.882%
change in OCF.
Selected Solution to Chapter 11 : Project analysis and Evaluation

Q20 Project Analysis McGilla Golf has decided to sell a new line of golf clubs. The clubs will sell for $600 per set and have a variable cost
of $240 per set. The company has spent $150,000 for a marketing study that determined the company will sell 50,000 sets per year
for seven years. The marketing study also determined that the company will lose sales of 12,000 sets of its high-priced clubs. The
high-priced clubs sell at $1,000 and have variable costs of $550. The company will also increase sales of its cheap clubs by 10,000
sets. The cheap clubs sell for $300 and have variable costs of $100 per set. The fixed costs each year will be $7,000,000. The
company has also spent $1,000,000 on research and development for the new clubs. The plant and equipment required will cost
$15,400,000 and will be depreciated on a straight-line basis. The new clubs will also require an increase in net working capital of
$900,000 that will be returned at the end of the project. The tax rate is 40 percent, and the cost of capital is 14 percent. Calculate
the payback period, the NPV, and the IRR.

Year 0 1 2 3 4 5 6 7
(i) Investment
Plant & equipmen -15,400,000
Mkt. study * ignored. Because it is sunk cost.
R&D * ignored. Because it is sunk cost.
NWC -600,000 600,000
Net Investment -16,000,000 600,000

(ii) Operation
a. Gain from sales of new clubs
price per set 600
cost per set 240
marginal gain per set 360
no. of sets sold 50,000
Marginal gain from new clubs 18,000,000 18,000,000 18,000,000 18,000,000 18,000,000 18,000,000 18,000,000

b. Sales gained from incremental cheap club sets

price per set 300
cost per set 100
marginal gain per set 200
no. of sets sold 10,000
Gain from cheap club sets 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000

c. Sales loss from decremental high-priced club sets

price per set 1,000
cost per set 550
marginal gain per set 450
no. of sets decreased -12,000
Loss from high-priced club -5,400,000 -5,400,000 -5,400,000 -5,400,000 -5,400,000 -5,400,000 -5,400,000

Net gain from new product 14,600,000 14,600,000 14,600,000 14,600,000 14,600,000 14,600,000 14,600,000
(a) + (b) + (c)
Fixed cost 7,000,000 7,000,000 7,000,000 7,000,000 7,000,000 7,000,000 7,000,000
Depreciation 2,200,000 2,200,000 2,200,000 2,200,000 2,200,000 2,200,000 2,200,000
EBIT 5,400,000 5,400,000 5,400,000 5,400,000 5,400,000 5,400,000 5,400,000
tax (40%) 2,160,000 2,160,000 2,160,000 2,160,000 2,160,000 2,160,000 2,160,000
Net income 3,240,000 3,240,000 3,240,000 3,240,000 3,240,000 3,240,000 3,240,000
+ plus non-cash expense 2,200,000 2,200,000 2,200,000 2,200,000 2,200,000 2,200,000 2,200,000
Operating cashflow 5,440,000 5,440,000 5,440,000 5,440,000 5,440,000 5,440,000 5,440,000

(iii) Project cashflow -16,000,000 5,440,000 5,440,000 5,440,000 5,440,000 5,440,000 5,440,000 6,040,000

solve for Payback period

Year 1 2 3 4 5 6 7
Investment -16,000,000 -16,000,000 -10,560,000 -5,120,000 320,000
cash return 5,440,000 5,440,000 5,440,000 5,440,000
Remain investment -10,560,000 -5,120,000 320,000 5,760,000
Payback period = 4 years
solve for NPV
5,440,000 5,440,000 5,440,000 5,440,000 5,440,000 5,440,000 6,040,000
NPV = -16,000,000
( 1 + 0.14) ( 1 + 0.14)2 ( 1 + 0.14)3 ( 1 + 0.14)4 ( 1 + 0.14)5 ( 1 + 0.14)6 ( 1 + 0.14)7

NPV = 6,638,737
solve for IRR
5,440,000 5,440,000 5,440,000 5,440,000 5,440,000 5,440,000 6,040,000
NPV = 0 = -16,000,000
( 1 + r) ( 1 + r)2 ( 1 + r)3 ( 1 + r)4 ( 1 + r)5 ( 1 + r)6 ( 1 + r)7
IRR = 28.217%
Selected Solution to Chapter 11 : Project analysis and Evaluation

Q21 Scenario Analysis In the previous problem, you feel that the values are accurate to within only 10 percent. What are the best-case
and worst-case NPVs? (Hint: The price and variable costs for the two existing sets of clubs are known with certainty; only the sales
gained or lost are uncertain.)

Normal Upper bound Lower bound

+ 10% - 10%
New club
price per set 600 660 540
cost per set 240 264 216
no. of sets sold 50,000 55,000 45,000
Incremental cheap club sets 10,000 11,000 9,000
Decremental high-priced sets -12,000 -13,200 -10,800
Fixed cost 7,000,000 7,700,000 6,300,000

Scenario Base case Worse case Best case

New club
price per set 600 540 660
cost per set 240 264 216
no. of sets sold 50,000 45,000 55,000
Incremental cheap club sets 10,000 9,000 11,000
Decremental high-priced sets -12,000 -13,200 -10,800
Fixed cost 7,000,000 7,700,000 6,300,000

Scenario Base case Worse case Best case

Marginal gain from new clubs 18,000,000 12,420,000 24,420,000
Gain from cheap club sets 2,000,000 1,800,000 2,200,000
Loss from high-priced club -5,400,000 -5,940,000 -4,860,000
Net gain from new product 14,600,000 8,280,000 21,760,000
Depreciation 2,200,000 2,200,000 2,200,000
Fixed cost 7,000,000 7,700,000 6,300,000
EBIT 5,400,000 -1,620,000 13,260,000
tax (40%) * 2,160,000 -648,000 5,304,000 * assume there's tax credit
Net income 3,240,000 -972,000 7,956,000
+ plus non-cash expense 2,200,000 2,200,000 2,200,000
Operating cashflow 5,440,000 1,228,000 10,156,000
NPV 6,638,737 -9,205,420 24,378,777