ECON 4410
Chapter 7: Questions 1-3, 5, 8-10, 12, 13, 18, 21
7.1 a. The payback period is the time that it takes for the cumulative undiscounted cash inflows to equal the
initial investment.
Project A:
Cumulative cash flows Year 1 = $9,500 = $9,500
Cumulative cash flows Year 2 = $9,500 + $6,000 = $15,500
Companies can calculate a more precise value using fractional years. To calculate the fractional payback
period, find the fraction of year 2’s cash flows that is needed for the company to have cumulative
undiscounted cash flows of $15,000. Divide the difference between the initial investment and the
cumulative undiscounted cash flows as of year 1 by the undiscounted cash flow of year 2.
Payback period = 1 + ($15,000 – $9,500) / $6,000
Payback period = 1.917 years
Project B:
Cumulative cash flows Year 1 = $10,500 = $10,500
Cumulative cash flows Year 2 = $10,500 + $7,000 = $17,500
Cumulative cash flows Year 3 = $10,500 + $7,000 + $6,000 = $23,500
To calculate the fractional payback period, find the fraction of year 3’s cash flows that is needed for the
company to have cumulative undiscounted cash flows of $18,000. Divide the difference between the
initial investment and the cumulative undiscounted cash flows as of year 2 by the undiscounted cash flow
of year 3.
Payback period = 2 + ($18,000 – $10,500 – $7,000) / $6,000
Payback period = 2.083 years
Since project A has a shorter payback period than project B has, the company should choose project A.
b. Discount each project’s cash flows at 15 percent. Choose the project with the highest NPV.
Project A:
NPV = –$15,000 + $9,500 / 1.15 + $6,000 / 1.152 + $2,400 / 1.153
NPV = –$624.23
Project B:
NPV = –$18,000 + $10,500 / 1.15 + $7,000 / 1.152 + $6,000 / 1.153
NPV = $368.54
The firm should choose Project B since it has a positive NPV, whereas Project A has
negative NPV.
Answers to End–of–Chapter Problems 7-1
7.2 To calculate the payback period, we need to find the time that the project has taken to recover its initial
investment. The cash flows in this problem are an annuity, so the calculation is simpler. If the initial cost is
$4,100, the payback period is:
Payback = 4 + ($220/$970) = 4.23 years
There is a shortcut to calculate the payback period if the future cash flows are an annuity. Just divide the
initial cost by the annual cash flow. For the $4,100 cost, the payback period is:
Payback = $4,100/$970 = 4.23 years
For an initial cost of $6,200, the payback period is:
Payback = $6,200/$970 = 6.39 years
The payback period for an initial cost of $8,000 is a little trickier. Notice that the total cash inflows after eight
years will be:
Total cash inflows = 8($970) = $7,760
If the initial cost is $8,000, the project never pays back. Notice that if you use the shortcut for annuity cash
flows, you get:
Payback = $8,000/$970 = 8.25 years
This answer does not make sense since the cash flows stop after eight years, so there is no payback period.
7.3 When we use discounted payback, we need to find the value of all cash flows today. The value today of the
project cash flows for the first four years is:
Value today of Year 1 cash flow = $6,000/1.14 = $5,263.16
Value today of Year 2 cash flow = $6,500/1.142 = $5,001.54
Value today of Year 3 cash flow = $7,000/1.143 = $4,724.80
Value today of Year 4 cash flow = $8,000/1.144 = $4,736.64
To find the discounted payback, we use these values to find the payback period. The discounted first year cash
flow is $5,263.16, so the discounted payback for an $8,000 initial cost is:
Discounted payback = 1 + ($8,000 – $5,263.16)/$5,001.54 = 1.55 years
For an initial cost of $13,000, the discounted payback is:
Discounted payback = 2 + ($13,000 – $5,263.16 – $5,001.54)/$4,724.80 = 2.58 years
Notice the calculation of discounted payback. We know the payback period is between two and three years, so
we subtract the discounted values of the Year 1 and Year 2 cash flows from the initial cost. This is the
numerator, which is the discounted amount we still need to make to recover our initial investment. We divide
Answers to End–of–Chapter Problems 7-2
this amount by the discounted amount we will earn in Year 3 to get the fractional portion of the discounted
payback.
If the initial cost is $18,000, the discounted payback is:
Discounted payback = 3 + ($18,000 – $5,263.16 – $5,001.54 – $4,724.80)/$4,736.64 = 3.64 years
7.5 The IRR is the interest rate that makes the NPV of the project equal to zero. So, the equation that defines the
IRR for this project is:
NPV = C0 + C1/(1+IRR) + C2/(1+IRR)2 + C3/(1+IRR)3 = 0
0 = –$11,000 + $5,500/(1+IRR) + $4,000/(1+IRR)2 + $3,000/(1+IRR)3
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
IRR = 7.46%
Since the IRR is less than the required return we would reject the project.
7.8 a. The profitability index is the present value of the future cash flows divided by the initial cost. So, for
Project Alpha, the profitability index is:
PIAlpha = [$1,200 / 1.10 + $1,100 / 1.102 + $900 / 1.103] / $2,300 = 1.164
And for Project Beta the profitability index is:
PIBeta = [$800 / 1.10 + $2,300 / 1.102 + $2,900 / 1.103] / $3,900 = 1.233
b. According to the profitability index, you would accept Project Beta. However, remember the profitability
index rule can lead to an incorrect decision when ranking mutually exclusive projects.
7.9 a. To have a payback equal to the project’s life, given C is a constant cash flow for N years:
C = I/N
b. To have a positive NPV, I < C A rN . Thus, C > I / A rN .
c. Benefits = C A rN = 2 × costs = 2I
C = 2I / A rN
7.10 a. The IRR is the interest rate that makes the NPV of the project equal to zero. So, the equation that
defines the IRR for this project is:
0 = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + C3 / (1 + IRR)3 + C4 / (1 + IRR)4
0 = $7,000 – $3,700 / (1 + IRR) – $2,400 / (1 + IRR)2 – $1,500 / (1 + IRR)3
– $1,200 / (1 +IRR)4
Answers to End–of–Chapter Problems 7-3
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
IRR = 12.40%
b. This problem differs from previous ones because the initial cash flow is positive and all future cash flows
are negative. In other words, this is a financing-type project, while previous projects were investing-type
projects. For financing situations, accept the project when the IRR is less than the discount rate. Reject
the project when the IRR is greater than the discount rate.
IRR = 12.40%
Discount Rate = 10%
IRR > Discount Rate
Reject the offer when the discount rate is less than the IRR.
c. Using the same reason as part b., we would accept the project if the discount rate is 20 percent.
IRR = 12.40%
Discount Rate = 20%
IRR < Discount Rate
Accept the offer when the discount rate is greater than the IRR.
d. The NPV is the sum of the present value of all cash flows, so the NPV of the project if the discount rate
is 10 percent will be:
NPV = $7,000 – $3,700 / 1.1 – $2,400 / 1.12 – $1,500 / 1.13 – $1,200 / 1.14
NPV = –$293.70
When the discount rate is 10 percent, the NPV of the offer is –$293.70. Reject the offer.
And the NPV of the project if the discount rate is 20 percent will be:
NPV = $7,000 – $3,700 / 1.2 – $2,400 / 1.22 – $1,500 / 1.23 – $1,200 / 1.24
NPV = $803.24
When the discount rate is 20 percent, the NPV of the offer is $803.24. Accept the offer.
e. Yes, the decisions under the NPV rule are consistent with the choices made under the IRR rule since the
signs of the cash flows change only once.
Answers to End–of–Chapter Problems 7-4
7.12a. The profitability index is the PV of the future cash flows divided by the initial investment. The cash flows
for both projects are an annuity, so:
PII = $18,000 A10
3
% / $30,000 = 1.492
PIII = $7,500 A10
3
% / $12,000 = 1.554
The profitability index decision rule implies that we accept project II, since PIII is greater than the PII.
b. The NPV of each project is:
NPVI = – $30,000 + $18,000 A10
3
% = $14,763.34
NPVII = – $12,000 + $7,500 A10
3
% = $6,651.39
The NPV decision rule implies accepting Project I, since the NPVI is greater than the NPVII.
c. Using the profitability index to compare mutually exclusive projects can be ambiguous when the
magnitudes of the cash flows for the two projects are of different scales. In this problem, project I is 2.5
times as large as project II and produces a larger NPV, yet the profitability index criterion implies that
project II is more acceptable.
7.13a. The equation for the NPV of the project is:
NPV = – $32,000,000 + $57,000,000/1.1 – $9,000,000/1.12= $12,380,165.29
The NPV is greater than 0, so we would accept the project.
b. The equation for the IRR of the project is:
NPV = –$32,000,000 + $57,000,000/(1+IRR) – $9,000,000/(1+IRR)2 = 0
From Descartes rule of signs, we know there are two IRRs since the cash flows change signs twice. From
trial and error, the two IRRs are:
IRR = 60.61%, – 82.49%
When there are multiple IRRs, the IRR decision rule is ambiguous. Both IRRs are correct; that is, both
interest rates make the NPV of the project equal to zero. If we are evaluating whether or not to accept this
project, we would not want to use the IRR to make our decision.
7.18 a. The payback period is the time that it takes for the cumulative undiscounted cash inflows to equal the
initial investment.
Dry Prepeg:
Answers to End–of–Chapter Problems 7-5
Cumulative cash flows Year 1 = $1,100,000 = $1,100,000
Cumulative cash flows Year 2 = $1,100,000 + $900,000 = $2,000,000
Payback period = 1 + ($600,000/$900,000) = 1.67 years
Solvent Prepeg:
Cumulative cash flows Year 1 = $375,000 = $375,000
Cumulative cash flows Year 2 = $375,000 + $600,000 = $975,000
Payback period = 1 + ($375,000/$600,000) = 1.63 years
Since the solvent prepeg has a shorter payback period than the dry prepeg, the company should choose
the solvent prepeg. Remember the payback period does not necessarily rank projects correctly.
b. The NPV of each project is:
NPVDry prepeg = –$1,700,000 + $1,100,000 / 1.10 + $900,000 / 1.102 + $750,000 / 1.103
NPVDry prepeg = $607,287.75
NPVSolvent perpeg = –$750,000 + $375,000 / 1.10 + $600,000 / 1.102 + $390,000 / 1.103
NPVSolvent prepeg = $379,789.63
The NPV criteria implies accepting the dry prepeg because it has the highest NPV.
c. The IRR is the interest rate that makes the NPV of the project equal to zero. So, the IRR of the dry
prepeg is:
0 = –$1,700,000 + $1,100,000 / (1 + IRR) + $900,000 / (1 + IRR)2 + $750,000 / (1 + IRR)3
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
IRRDry prepeg = 30.90%
And the IRR of the solvent prepeg is:
0 = –$750,000 + $375,000 / (1 + IRR) + $600,000 / (1 + IRR)2 + $390,000 / (1 + IRR)3
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
IRRSolvent prepeg = 36.51%
The IRR criteria implies accepting the solvent prepeg because it has the highest IRR. Remember the IRR
does not necessarily rank projects correctly.
d. Incremental IRR analysis is necessary. The solvent prepeg has a higher IRR, but is relatively smaller in
terms of investment and NPV. In calculating the incremental cash flows, we subtract the cash flows from
Answers to End–of–Chapter Problems 7-6
the project with the smaller initial investment from the cash flows of the project with the large initial
investment, so the incremental cash flows are:
Year 0 Year 1 Year 2 Year 3
Dry prepeg –$1,700,000 $1,100,000 $900,000 $750,000
Solvent prepeg –750,000 375,000 600,000 390,000
Dry prepeg – Solvent –$950,000 $725,000 $300,000 $360,000
prepeg
Setting the present value of these incremental cash flows equal to zero, we find the incremental IRR is:
0 = –$950,000 + $725,000 / (1 + IRR) + $300,000 / (1 + IRR)2 + $360,000 / (1 + IRR)3
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
Incremental IRR = 25.52%
For investing-type projects, we accept the larger project when the incremental IRR is greater than the
discount rate. Since the incremental IRR, 25.52%, is greater than the required rate of return of 10 percent,
we choose the Dry Prepeg.
7.21Given the six-year payback, the worst case is that the payback occurs at the end of the sixth year. Thus, the
worst case:
NPV = –$434,000 + $434,000/1.126 = – $214,122.09
The best case has infinite cash flows beyond the payback point. Thus, the best-case NPV is infinite.
Chapter 7: Questions 1-3, 5, 8-10, 12, 13, 18, 21
Calculator Solutions
7.1 b. Project A
CFo –$15,000 CFo –$18,000
C01 $9,500 C01 $10,500
F01 1 F01 1
C02 $6,000 C02 $7,000
F02 1 F02 1
C03 $2,400 C03 $6,000
F03 1 F03 1
I = 15% I = 15%
Answers to End–of–Chapter Problems 7-7
