Tutorial & Computer Lab Solutions – Week 8

Parrino et al. Chapter 8

Instructions
• Spend first 30 min on short answer questions 1-4
• Spend the remaining 60 min on questions 6-12 which are Excel exercises from
Parrino et al. Chapter 8 (students may work in groups of up to 3 people).

Note: Tutors may not be able to cover all tutorial questions/excel exercises during the
tutorial time. Students are expected to complete all remaining exercises as part of their own
self-study.

1. Why are capital investments considered the most important decisions made by a
company’s management?

Capital investments are the most important decisions made by a company’s management,
because they usually involve large cash outflows and once made are not easily reversed.
These are usually long-term projects that will define the company’s line of business and
significantly contribute to the total revenue figure for years to come.

2. (a) What is the NPV of a project?

NPV is simply the difference between the present value of a project’s expected future
cash flows and its cost. It is the recommended technique used to value capital
investments, as it takes into account both the timing of the cash flows and their risk.

(b) What are the five steps used in NPV analysis?

The five-step process used in the NPV analysis can be listed as follows:
(1) Determine the cost of the project.
(2) Estimate the project’s future cash flows over its expected life.
(3) Determine the riskiness of a project and the appropriate cost of capital.
(4) Calculate the project’s NPV.
(5) Make a decision.
3. (a) What is the payback period?

The payback period is defined as the number of years it takes to recover the project’s
initial investment. All other things being equal, the project with the shortest payback
period is usually the optimal investment.

(b) Why does the payback period provide a measure of a project’s liquidity risk?

The payback period determines how quickly you recover your investment in a project.
Thus, it serves as a good measure of the project’s liquidity.

(c) What are the main shortcomings of the payback method?

The payback method does not account for time value of money, nor does it distinguish
between high- and low-risk projects. In addition, there is no rationale behind choosing the
cut-off criteria. For all these reasons, the payback method is not the ideal capital decision
rule.

4. (a) What is the IRR method?

The IRR, or the internal rate of return, is the discount rate that makes the net present
value of the project’s future cash flows zero. The IRR determines whether the project’s
return rate is higher or lower than the required rate of return, which is the company’s cost
of capital. As a rule, a project should be accepted if the IRR exceeds the company’s cost
of capital; otherwise the project should be rejected.

b) Name two situations in which the IRR method and NPV method may give
different results for capital budgeting decisions?

The two methods may give different results when (i) comparing two mutually exclusive
projects and (ii) evaluating projects with non-conventional cashflows (a conventional
project cash flow in capital budgeting is one in which an initial cash outflow is followed
by one or more future cash inflows).

Given all the different methods to evaluate capital investment decisions, the NPV
method is the preferred valuation tool as it accounts for both time value of money and the
project’s risk. Furthermore, NPV is not sensitive to nonconventional projects, and
therefore it is superior to the IRR technique and it gives a measure of the value
increase/decrease to the company by taking the project.
Exercises

Summary of key equations

5. Premium Manufacturing Ltd is evaluating two forklift systems to use in its plant that
produces the towers for a wind farm. The costs and the cash flows from these systems
are shown here. If the company uses a 12 percent discount rate for all projects,
determine which forklift system should be purchased using the net present value (NPV)
approach.

Year 0 Year 1 Year 2 Year 3

Otis Forklifts −$3 123 450 $979 225 $1 358 886 $2 111 497
Craigmore Forklifts −$4 137 410 $875 236 $1 765 225 $2 865 110

1. NPV for Otis Forklifts:

n CFt
NPV = ∑ t
t = 0 (1 + k )

$979,225 $1,358,886 $2,111,497

= −$3,123,450 + + +
(1 + 0.12)1 (1.12) 2 (1.12) 3
= −$3,123,450 + $874,308 + $1,083,296 + $1,502,922
= $337,075
 2. NPV for Craigmore Forklifts:

n CFt
NPV = ∑ t
t = 0 (1 + k )

$875,236 $1,765,225 $2,865,110

= −$4,137,410 + + +
(1 + 0.12)1 (1.12) 2 (1.12) 3
= −$4,137,410 + $781,461 + $1,407,229 + $2,039,227
= $90,606

Premium should purchase the Otis forklift since it has a larger NPV.

6. Refer to the problem in question 5. Calculate the IRR for each of the two systems. Is the
choice different from the one determined by NPV?

IRR for two forklift systems

1. Otis Forklifts:

First calculate the IRR by the trial-and-error approach:

At k=12%, NPV (Otis) = $337,075 > 0

Use a higher discount rate to get NPV = 0! At k = 15%,

$979,225 $1,358,886 $2,111,497

NPV = −$3,123,450 + + +
(1 + 0.15)1 (1.15) 2 (1.15) 3
= −$3,123,450 + $851,500 + $1,027,513 + $1,388,344
= $143,907.

Try a higher rate. At k = 17%,

NPV = −$3,123,450 + $836,944 + $992,685 + $1,318,357

= $24,536.

Try a higher rate. At k = 17.5%,

NPV = −$3,123,450 + $833,383 + $984,254 + $1,301,598

= −$4,215

Thus the IRR for Otis is less than 17.5 percent. Using a financial calculator, you
can find that the exact rate to be 17.43 percent.
 2. Craigmore Forklifts:

First calculate the IRR by the trial-and-error approach:

NPV (Craigmore) = $90,606 > 0

Use a higher discount rate to get NPV = 0! At k = 15%,

$875,236 $1,765,225 $2,865,110

NPV = −$4,137,410 + + +
(1.15)1 (1.12) 2 (1.12) 3
= −$4,137,410 + $761,075 + $1,334,764 + $1,883,856
= −$157,715

Try a lower rate. At k = 13%,

NPV = −$4,137,410 + $774,545 + $1,382,430 + $1,985,665

= $5,230

Try a higher rate. At k = 13.1%,

NPV = −$4,137,410 + $773,860 + $1,379,987 + $1,980,403

= −$3,161

Thus the IRR for Craigmore is less than 13.1 percent. The exact rate is 13.06
percent. Based on the IRR, we would still pick Otis over Craigmore forklift
systems.

7. Rutledge Ltd has invested $100 000 in a project that will produce cash flows of $45
000, $37 500 and $42 950 over the next 3 years. Find the payback period for the
project.

Payback period for Rutledge project:

Cumulative
Year CF Cash Flow
0 (100,000) (100,000)
1 45,000 (55,000)
2 37,500 (17,500)
3 42,950 25,450

PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 2 + ($17,500 / $42,950)
= 2.41 years
8. Perryman Crafts Ltd is evaluating two independent capital projects that will each
cost the company $250 000. The two projects will provide the following cash flows:

Year Project A Project B

1 $80 750 $32 450
2 $93 450 $76 125
3 $40 235 $153 250
4 $145 655 $96 110

Which project will be chosen if the company’s payback criterion is three years? What if
the company accepts all projects as long as the payback period is less than five years?

Payback periods for Perryman projects A and B:

Project A
Cumulative
Year Cash Flow Cash Flows
0 $(250,000) $(250,000)
1 80,750 (169,250)
2 93,450 (75,800)
3 40,235 (35,565)
4 145,655 110,090

Project B
Cumulative
Year Cash Flow Cash Flows
0 $(250,000) $(250,000)
1 32,450 (217,550)
2 76,125 (141,425)
3 153,250 11,825
4 96,110 107,935

Payback period for Project A:

PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 3 + ($35,565 / $145,655)
= 3.24 years

Payback period for Project B:

PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 2 + ($141,425/ $153,250)
= 2.92 years

If the payback period is three years, project B will be chosen. If the payback criterion is five
years, then both A and B will be chosen.
9. Discounted payback: Fluid Communications Ltd is investing $9 365 000 in new
technologies. The company expects significant benefits in the first 3 years after
installation (as can be seen by the cash flows), and a constant amount for 4 more
years. What is the discounted payback period for the project assuming a discount
rate of 10 per cent?

Years 1 2 3 4–7
Cash flows $2 265 433 $4 558 721 $3 378 911 $1 250 000

Discount rate = k = 10%

Cumulative Cumulative
Year CF CF PVCF PVCF
0 $(9,365,000) $(9,365,000) $(9,365,000) $(9,365,000)
1 2,265,433 (7,099,567) 2,059,485 (7,305,515)
2 4,558,721 (2,540,846) 3,767,538 (3,537,977)
3 3,378,911 838,065 2,538,626 (999,352)
4 1,250,000 2,088,065 853,767 (145,585)
5 1,250,000 3,338,065 776,152 630,567
6 1,250,000 4,588,065 705,592 1,336,159
7 1,250,000 5,838,065 641,448 1,977,607

PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 4 + ($145,585 / $1,250,000)
= 4.12 years

10. Modified internal rate of return (MIRR): Mornington Bakeries has recently purchased
equipment at a cost of $650 000. The company expects to generate cash flows of $275
000 in each of the next 4 years. The company’s cost of capital is 14 per cent. What is the
MIRR for this project?

PV of costs = $650 000

Length of project = n = 4 years
Cost of capital = k = 14%
Annual cash flows = CFt = $275 000

TV = CF1 (1 + k ) n − 1 + CF2 (1 + k ) n − 2 +  + CFn (1 + k ) n − n

= $275,000(1.14)3 + $275,000(1.14) 2 + $275,000(1.14)1 + $275,000(1.14)0
= $407,425 + $357,390 + $313,500 + $275,000 = $1,353,315

Now we can solve for the MIRR using Equation 8.5.

 TV
PVCosts =
(1 + MIRR ) t
$1,353,315
$650,000 =
(1 + MIRR ) 4
$1,353,315
(1 + MIRR ) 4 = = 2.0820
$650,000
1
(1 + MIRR ) = (3.5962) 4 = 1.2012
MIRR = 0.2012 = 20.1%

11. Draconian Measures Ltd. is evaluating two independent projects. The

company uses a 13.8 percent discount rate for such projects. Cost and cash flows are
shown in the table. What are the NPVs of the two projects?

Year Project 1 Project 2

0 –$8 425 375 –$11 368 000
1 $3 225 997 $2 112 589
2 $1 775 882 $3 787 552
3 $1 375 112 $3 125 650
4 $1 176 558 $4 115 899
5 $1 212 645 $4 556 424
6 $1 582 156
7 $1 365 882

Project 1:
Cost of Project 1 = $8,425,375
Length of project = n = 7 years
Required rate of return = k = 13.8%

n FCFt
NPV = ∑ t
t = 0 (1 + k )

$3,225,997 $1,775,882 $1,375,112 $1,176,558 $1,212,645

= −$8,425,375 + + + + +
(1.138)1 (1.138) 2 (1.138)3 (1.138) 4 (1.138)5
$1,582,156 $1,365,882
+ +
(1.138)6 (1.138)7
= −$8,425,375 + $2,834,795 + $1,371,291 + $933,064 + 701,527 + $635,364 + $728,443
+ $552,608
= −$668,283

Since Project 1 NPV is negative, we reject this project.

 Project 2:

Cost of Project 2 = $11,368,000

Length of project = n = 5 years
Required rate of return = k = 13.8%

n FCFt
NPV = ∑ t
t = 0 (1 + k )

$2,112,589 $3,787,552 $3,125,650 $4,115,889 $4,556,424

= −$11,368,000 + + + + +
(1.138)1 (1.138) 2 (1.138)3 (1.138) 4 (1.138)5
= −$11,368,000 + $1,856,405 + $2,924,651 + $2,120,868 + $2,454,119 + $2,387,332
= $375,375

Since Project 2 NPV is positive, we accept this project.

12. Refer to the problem in question 11.

a. What are the IRRs for both projects?
b. Does the IRR decision criterion differ from the earlier decisions?
c. Explain how you would expect the management of Draconian Measures to
decide.
d. If the two projects were mutually exclusive, rather than independent, how
should management decide which project is preferred?

a. Project 1:

At the required rate of return of 13.8 percent, Project 1 has a NPV of $(668,283).
To find the IRR, try lower rates.

Try IRR = 11%

n FCFt
NPV = ∑ t
t = 0 (1 + k )

$3,225,997 $1,775,882 $1,375,112 $1,176,558 $1,212,645

= −$8,425,375 + + + + +
(1.11)1 (1.11) 2 (1.11)3 (1.11) 4 (1.11)5
$1,582,156 $1,365,882
+ +
(1.11)6 (1.11)7
= −$8,425,375 + $2,906,304 + $1,441,346 + $1,005,470 + $775,035 + $719,646
+ $845,885 + $657,889
= −$73,801
Try a lower rate, IRR=10.7%

n FCFt
NPV = ∑ t
t = 0 (1 + k )

$3,225,997 $1,775,882 $1,375,112 $1,176,558 $1,212,645

= −$8,425,375 + + + + +
(1.107)1 (1.107) 2 (1.107)3 (1.107) 4 (1.107)5
$1,582,156 $1,365,882
+ +
(1.107)6 (1.107)7
= −$8,425,375 + $3,225,997 + $1,775,882 + $1,375,112 + $1,176,558 + $1,212,645
+ $1,582,156 + $1,365,882
= −$5,235

The IRR of the project is approximately 10.7 percent. Using a financial calculator,
we find that the IRR is 10.677 percent.

Project 2:

At the required rate of return of 13.8 percent, Project 1 has a NPV of 375,375. To
find the IRR, try higher rates.

Try IRR = 15%

n FCFt
NPV = 0 = ∑ t
t = 0 (1 + IRR )

$2,112,589 $3,787,552 $3,125,650 $4,115,889 $4,556,424

0 = −$11,368,000 + + + + +
(1.15)1 (1.15) 2 (1.15) 3 (1.15) 4 (1.15)5
= −$11,368,000 + $1,837,034 + $2,863,933 + $2,055,166 + $2,353,279 + $2,265,348
= $6,760

Try IRR = 15.1%.

n FCFt
NPV = 0 = ∑ t
t = 0 (1 + IRR )

$2,112,589 $3,787,552 $3,125,650 $4,115,889 $4,556,424

0 = −$11,368,000 + + + + +
(1.151)1 (1.151) 2 (1.151) 3 (1.151) 4 (1.151)5
= −$11,368,000 + $1,835,438 + $2,858,959 + $2,049,814 + $2,345,111 + $2,255,524
= −$23,154

The IRR of the project is between 15 and 15.1 percent. Using a financial
calculator, we find that the IRR is 15.023 percent.
b. Based on the IRR, Project 1 will be rejected and Project 2 will be accepted. These
decisions are identical to those based on NPV.

c. Management would use the decision spelled out by NPV, although in this case the
IRR has come up with the same decision.

d. The IRR method cannot be used to compare two mutually exclusive projects.
Management should use the NPV method, which in this example would result in
Project 2 being preferred.