Chapter 9 Homework key I’ve edited the questions as indicated on the assignment web page. Also note that many of the present values in the key here are shown in the key using PV factors from tables. I expect you to do the problems with your calculator and show your calculator inputs and the result. 1. A project has the following cash flows C0 C1 C2 ($700) $200 $500 a. What is the project’s payback period? b. Calculate the projects NPV at 12%. c. Calculate the project’s IRR C3 $244 SOLUTION: a. The cumulative cash flow is Year 0 1 2 3 Cash Flow ($700) $200 $500 $244 Cumulative ($700) ($500) 0 $244 Cumulative cash flow is zero after two years, hence the payback period is two years. b. Year 0 1 2 3 Ci ($700) $200 $500 $244 PVFk,i 1.0 .8929 .7972 .7118 Ck,i PVFk,i ($700) $179 $399 $174 NPV = $ 52 c. With the cash flows above entered in your calculator, hit the IRR key and find that the IRR is 16.03% 3. Clancy Inc. is considering a project with the following cash flows. C0 C1 C2 C3 ($7,800) $2,300 $3,500 $4,153 a. Clancy has a policy of rejecting all projects that don’t pay back within three years outright, and analyzing those that do more carefully with time value based methods. Does this project warrant further consideration? b. Should Clancy accept the project based on its NPV if the company’s cost of capital is 8%? c. Based on IRR, what conclusion will the firm reach? SOLUTION: a. The cumulative cash flow is Year 0 Cash Flow ($7,800) Cumulative ($7,800) 1 $2,300 ($5,500) 2 $3,500 ($2,000) 3 . $4,153 $2,153 Cumulative cash flow is negative after two years and positive after three, hence the payback period is between two and three years (2 + 2000/4153 = 2.48). Hence Clancy’s policy would require further evaluation using time value based methods. 1 b. and c. The project’s NPV at 8% is calculated as follows: Year Ci PVF8,i Ci PVF8,i 0 ($7,800) 1.0 ($7,800) 1 $2,300 .9259 $2,130 2 $3,500 .8573 $3,001 3 $4,153 .7938 $3,297 NPV = $ 628 The project has a positive NPV which implies that it should be accepted. The IRR, using the cash flows above is: 12%, which is above the cost of capital of 8%. Therefore the investment should be accepted. 5. Hamstring Inc. is considering a project with the following cash flows: C0 ($25,000) C1 $10,000 C2 $12,000 C3 $5,000 C4 $8,000 The company is reluctant to consider projects with paybacks of more than three years. If projects pass the payback screen, they are considered further by means of the NPV and IRR methods. The firm's cost of capital is 9%. a. What is the project's payback period? Should the project be considered further? b. What is the project's NPV? Does NPV indicate acceptance on a stand-alone basis? c. Calculate the project's IRR using your calculator. Does IRR indicate acceptance on a standalone basis? SOLUTION: a. C0 Cash flows: ($25,000) C1 C2 $10,000 $12,000 $5,000 $8,000 ($3,000) $2,000 $10,000 Cumulative cash flows: ($25,000) ($15,000) C3 C4__ Payback period = 2.6 yrs. Yes, since payback < 3yrs b. NPV = $25,000 + $10,000[PVF9,1] + $12,000[PVF9,2] + $5,000[PVF9,3] + $8,000[PVF9,4] NPV = $25,000 + $10,000(.9174) + $12,000(.8417) + $5,000(.7722) + $8,000(.7084) NPV = $3,803 Yes, NPV does indicate acceptance on a stand-alone basis. c. Enter the cash flows into your calculator and find the IRR is approximately 16.3% which implies acceptance of the project since 16.3% > 9%. 6. Project Alpha requires an initial outlay of $35,000 and results in a single cash inflow of $56,367.50 after five years. a. If the cost of capital is 8% what are Alpha's NPV? Is the project acceptable under NPV? b. What is project Alpha's IRR? Is it acceptable under IRR? 2 c. What is Alpha's NPV if the cost of capital is 12%? Is the project acceptable under that condition. d. What is Alpha's payback period? Does payback make much sense for a project like Alpha? Why? SOLUTION: a. NPV = $35,000 + $56,367.50 [PVF8,5] = $35,000 + $56,367.50 (.6806) = $35,000 + $38,363.72 = $3,363.72 Acceptable since NPV > 0. b. Using: N 5, PV= -35000, FV=56375.5; PMT=0: solve I = 10, so IRR = 10% Acceptable since IRR > 8%. c. NPV = $35,000 + $56,367.50 [PVF12,5] = $35,000 + $56,367.50 (.5674) = $35,000 + $31,982.92 = $3,017.08 Unacceptable since NPV < 0. d. 4.62 years. Yes, it payback makes sense because it takes about five years to recover the absolute value of the investment regardless of the fact that the entire return comes in a single sum. 7. The Sampson Company is considering a project that requires an initial outlay of $75,000 and produces cash inflows of $20,806 each year for five years. Sampson's cost of capital is 10%. a. Calculate the project's payback period by making a single division rather than accumulating cash inflows. Why is this possible in this case? b. Calculate the project's IRR recognizing the fact that the cash inflows are an annuity. Is the project acceptable? c. What is the project's NPV? Is it acceptable according to NPV rules? SOLUTION: a. $75,000 / $20,806 = 3.6 years The calculation is possible because the returns are constant in amount and regular in time (an annuity). b. N=5, PV= -75000; FV=0; PMT= 20806; solve I = 12%; IRR=12% The project is acceptable since IRR > k = 10%. c. NPV = $75,000 + $20,806 [PVFA10,5] = $75,000 + $20,806 (3.7908) = $75,000 + $78,871 = $3,871 The project is acceptable since NPV > 0. 15. Bagel Pantry Inc. is considering two mutually exclusive projects with widely differing lives. The company's cost of capital is 12%. The project cash flows are summarized as follows: C0 Project A ($25,000) Project B ($23,000) 3 C1 C2 C3 C4 C5 C6 C7 C8 C9 $14,742 $14,742 $14,742 $ $ $ $ $ $ $ $ $ 6,641 6,641 6,641 6,641 6,641 6,641 6,641 6,641 6,641 a. Compare the projects by using Payback. b. Compare the projects by using NPV. c. Compare the projects by using IRR. e. Compare the projects by using the EAA method. f. Chose a project and justify your choice. SOLUTION: a. Payback Period A: P/B = $25,000 / $14,742 = 1.7 years B: P/B = $23,000 / $6,641 = 3.5 years Project A is preferred. b. c. e. NPV = C0 + C [PVFAk,n] A: NPV = $25,000 + $14,742 [PVFA12,3] = $25,000 + $14,742 (2.4018) = $10,407 B: NPV = $23,000 + $6,641 [PVFA12,9] = $23,000 + $6,641 (5.3282) = $12,385 Project B is preferred. Enter CFs into calculator A: IRR = 35% B: IRR = 25% Project A is preferred. A: N=3, I=12; PV= -10407; solve PMT = $4,333 = EAA B: N=9; I=12; PV= -12385; solve PMT = $2324 = EAA Project A is preferred, because it has the larger EAA. f. Project A is preferred on all counts except the original NPV calculation, and that disparity is due to the time horizon problem. Hence, if A can be repeated, then A is the best choice. 17. Provide the missing information for the following projects. 4 Project Initial Investment Length (in years) Annual Cash Flow Cost of Capital NPV A $100,000 5 $35,000 8% B $200,000 4 13% C $300,000 7 $50,000 D $400,000 $56,098 9% E 6 $75,000 10% SOLUTION: A. PMT = 35,000 N=5 I/Y = 8 FV = 0 PV = ? = 139,744.85 which make the NPV = $39,744.85 18. $35,000 $15,000 $20,000 $25,000 B. PV = (235,000) N=4 I/Y = 13 FV = 0 PMT = ? = $79,005.64 C. PV = (315,000) PMT = 50,000 N=7 FV = 0 I/Y = ? = 2.71% D. PV = (420,000) I/Y = 9 PMT = 56,098 FV = 0 N = ? = 13 E. PMT = 75,000 N=6 I/Y = 10 FV = 0 PV = ? = 326,644.55 which means the Initial investment was $25,000 less or $301,644.55 Calculate IRRs for the projects in the previous problem. SOLUTION: PV PMT N FV I/Y A (100,000) 35,000 5 0 22.11% B (200,000) 79,005.64 4 0 21.19% C (300,000) 50,000 7 0 4.01% D (400,000) 56,098 13 0 9.93% E (301,644.55) 75,000 6 0 12.78% 5 23. Zuker Distributors handles the warehousing of perishable foods and is considering replacing one of its primary cold storage units. One supplier has offered a unit for $250,000 with an expected life of 10 years. The unit is projected to reduce electricity costs by $50,000 per year. However, it requires a $20,000 refurbishing every two years, beginning two years after purchase. Another supplier has offered a cold storage unit with similar capabilities for $300,000. It will produce the same savings in electricity costs, but requires refurbishing every five years at a cost of $40,000. Zuker’s cost of capital is 8.5%. Use NPV to determine which cold storage unit Zuker should select. SOLUTION: 2-year refurb. 5-year refurb. CF0 CF1 CF2 CF3 CF4 CF5 CF6 CF7 CF8 CF9 CF10 (250,000) 50,000 30,000 50,000 30,000 50,000 30,000 50,000 30,000 50,000 30,000 (300,000) 50,000 50,000 50,000 50,000 10,000 50,000 50,000 50,000 50,000 10,000 I = 8.5% NPV 15,129 (16,226) NPV tells us to select the $250,000 storage unit. 6