Solutions Guide: This is meant as a solutions guide



Solutions Guide:   This is meant as a solutions guide. Please try reworking the questions and reword the answers to essay type parts so as to guarantee that your answer is an original. Do not submit as your own.

Your division is considering two investment projects, each of which requires an up-front expenditure of $25 million in Year 0. You estimate the cost of capital is 10% and the investments will produce the following after-tax cash flows (in millions of dollars):

Year Project A Project B

1 5 20

2 10 10

3 15 8

4 20 6

a. What is the regular payback period for each of the projects?

b. What is the discounted payback period for each of the projects?

c. (1) If the two projects are independent and the cost of capital is 10%, which project or projects should the firm undertake when evaluated by the NPV and IRR criteria? (2) Why? Display the 2 NPVs and IRRs.

d. (1) If the two projects are mutually exclusive and the cost of capital is 10%, which, if any, project should the firm undertake when evaluated by the NPV and IRR criteria? (2) Why? (3) If you selected a single project, why did you not select both projects?

e. In part (d), if the NPV and IRR criteria suggest a different priority ranking and different choices, to what do you attribute this conflict [in one sentence]?

f. If the two projects are mutually exclusive and the cost of capital is 15%, which project should the firm undertake? Display the two NPVs.

a. Payback A (cash flows in thousands):

Annual

Period Cash Flows Cumulative

0 ($25,000) ($25,000)

1 5,000 (20,000)

2 10,000 (10,000)

3 15,000 5,000

4 20,000 25,000

PaybackA = 2 + $10,000/$15,000 = 2.67 years.

Payback B (cash flows in thousands):

Annual

Period Cash Flows Cumulative

0 ($25,000) $25,000)

1 20,000 (5,000)

2 10,000 5,000

3 8,000 13,000

4 6,000 19,000

PaybackB = 1 + $5,000/$10,000 = 1.50 years.

b. Discounted payback A (cash flows in thousands):

Annual Discounted @10%

Period Cash Flows Cash Flows Cumulative

0 ($25,000) ($25,000.00) ($25,000.00)

1 5,000 4,545.45 ( 20,454.55)

2 10,000 8,264.46 ( 12,190.09)

3 15,000 11,269.72 ( 920.37)

4 20,000 13,660.27 12,739.90

Discounted PaybackA = 3 + $920.37/$13,660.27 = 3.07 years.

Discounted payback B (cash flows in thousands):

Annual Discounted @10%

Period Cash Flows Cash Flows Cumulative

0 ($25,000) ($25,000.00) ($25,000.00)

1 20,000 18,181.82 ( 6,818.18)

2 10,000 8,264.46 1,446.28

3 8,000 6,010.52 7,456.80

4 6,000 4,098.08 11,554.88

Discounted PaybackB = 1 + $6,818.18/$8,264.46 = 1.825 years.

c. NPVA = $12,739,908; IRRA = 27.27%.

NPVB = $11,554,880; IRRB = 36.15%.

Both projects have positive NPVs, so both projects should be undertaken. Also, both IRR’s are higher than the cost of capital, so according to the IRR, both should be undertaken.

d. Only Project A should be undertaken since it has a higher NPV. IRR is deceptive in cases of mutually exclusive investments, therefore when dealing with mutually exclusive projects; we use the NPV method for choosing the best project. I selected one project because the investments are mutually exclusive, and by definition in case of mutually exclusive investments, only one investment can be undertaken.

e. When dealing with mutually exclusive projects; we use the NPV method for choosing the best project.

f. At a discount rate of 15%, NPVA = $8,207,071.

At a discount rate of 15%, NPVB = $8,643,390.

At a discount rate of 15%, Project B has the higher NPV; consequently, it should be accepted.

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