F402 In-Class Exercise

September 3, 2020

1. Mica Incorporated is debating using Payback Period versus Discounted Payback Period
for small dollar projects. The Information Officer has submitted a new computer project
of $15,000 cost. The cash flows will be $5,000 each year for the next five years. The cut-
off period used by Mica Incorporated is three years. The Information Officer states it
doesn’t matter what model the company uses for the decision, it is clearly an acceptable
project. You’ve just been hired as a financial analyst at Mica Inc. How would you
respond to the Information Officer?
I would choose discounted payback period since we need to consider the time value of money if
the discount rate is relatively high when we calculate the project.
But the IRR is 20% and relatively high, it is reasonable to use normal payback period.

2. Sam and Pat were having a discussion about which financial model to use for their new
business. Sam supports NPV and Pat supports IRR. Pat argues that IRR is easier to use
than NPV since you don’t have to determine the discount rate with IRR. Sam says he
remembers from his finance class that IRR is actually harder to use, he just can’t
remember why. They turn to you to help them decide. What do you tell them?

3. If a project with conventional cash flows has a payback period less than the project’s life,
can you definitively state the algebraic sign of the NPV? Why or why not? If you know
that the discounted payback period is less than the project’s life, what can you say about
the NPV? Explain.
No, it could be either negative and positive.
No, depends on whether the discount rate is higher, less, or equal to IRR.

4. A project has perpetual cash flows of C per period, a cost of I, and a required return of R.
What is the relationship between the project’s payback and its IRR? What implications
does your answer have for long-lived projects with relatively constant cash flows?

IRR=C/I, Payback=I/C. So the payback and IRR are opposite.

The greater IRR, the sooner project pays back
 5. Ted, a project manager, wants to invest in a project with an initial cost of $58,500 and
cash flows of $32,400 and $38,500 in Years 1 and 2. Rosita, his boss, requires a discount
rate of 10 percent and also a return of $1.10 in today's dollars for every $1 invested. Will
Ted get his project approved? Why or why not?

IRR=13.4%
PI=1.05
no; while the project returns more than 10 percent it does meet $1.10 per $1 requirement.