CHAPTER 9

Capital Budgeting Decision

Criteria
CHAPTER ORIENTATION
Capital budgeting involves the decision making process with respect to investment in fixed
assets; specifically, it involves measuring the incremental cash flows associated with
investment proposals and evaluating the attractiveness of these cash flows relative to the
project's costs. This chapter focuses on the various decision criteria. It also examines how
to deal with complications in the capital budgeting process including mutually exclusive
projects and capital rationing.

CHAPTER OUTLINE

I. Methods for evaluating projects

A. The payback period method
1. The payback period of an investment tells the number of years
required to recover the initial investment. The payback period is
calculated by adding the cash flows up until they are equal to the
initial fixed investment.
2. Although this measure does, in fact, deal with cash flows and is easy
to calculate and understand, it ignores any cash flows that occur after
the payback period and does not consider the time value of money
within the payback period.
3. To deal with the criticism that the payback period ignores the time
value of money some firms use the discounted payback period. The
discounted payback period method is similar to the traditional
payback period except that it uses discounted net cash flows rather
than actual undiscounted net cash flows in calculating the payback
period.
4. The discounted payback period is defined as the number of years
needed to recover the initial cash outlay from the discounted net cash
flows.

216
B. Present-value methods
1. The net present value of an investment project is the present value of
the cash inflows less the present value of the cash outflows. By
assigning negative values to cash outflows, it becomes
n
FCFt
NPV =  (1  k) t
- IO
t 1

where FCFt = the annual free cash flow in time period t (this
can take on either positive or negative values)
k = the required rate of return or appropriate discount rate
or cost of capital
IO = the initial cash outlay
n = the project's expected life
a. The acceptance criteria are
accept if NPV  0
reject if NPV  0
b. The advantage of this approach is that it takes the time value
of money into consideration in addition to dealing with cash
flows.
2. The profitability index is the ratio of the present value of the expected
future net cash flows to the initial cash outlay, or
n
FCFt
profitability index =  (1  k) t
t 1
IO
a. The acceptance criteria are
accept if PI  1.0
reject if PI  1.0
b. The advantages of this method are the same as those for the
net present value.
c. Either of these present-value methods will give the same
accept-reject decisions to a project.

217
C. The internal rate of return is the discount rate that equates the present value
of the project's future net cash flows with the project's initial outlay. Thus the
internal rate of return is represented by IRR in the equation below:
n
FCFt
IO =  (1  IRR) t
t 1

1. The acceptance-rejection criteria are:

accept if IRR  required rate of return
reject if IRR  required rate of return
The required rate of return is often taken to be the firm's cost of
capital.
2. The advantages of this method are that it deals with cash flows and
recognizes the time value of money; however, the procedure is rather
complicated and time-consuming. The net present value profile
allows you to graphically understand the relationship between the
internal rate of return and NPV. A net present value profiles is
simply a graph showing how a project’s net present value changes as
the discount rate changes. The IRR is the discount rate at which the
NPV equals zero.
3. The primary drawback of the internal rate of return deals with the
reinvestment rate assumption it makes. The IRR implicitly assumes
that the cash flows received over the life of the project can be
reinvested at the IRR while the NPV assumes that cash flows over the
life of the project are reinvested at the required rate of return. Since
the NPV makes the preferred reinvestment rate assumption it is the
preferred decision technique. The modified internal rate of return
(MIRR) allows the decision maker the intuitive appeal of the IRR
coupled with the ability to directly specify the appropriate
reinvestment rate.
a. To calculate the MIRR we take all the annual after tax cash
inflow, ACIFt's, and find their future value at the end of the
project's life - this is called the terminal value or TV. All cash
outflows, ACOFt, are then discounted back to present at the
required rate of return. The MIRR is the discount rate that
equates the present value of the cash outflows with the present
value of the project's terminal value.
b. If the MIRR is greater than or equal to the required rate of
return the project should be accepted.

218
 ANSWERS TO
END-OF-CHAPTER QUESTIONS

9-1. Capital budgeting decisions involve investments requiring rather large cash outlays
at the beginning of the life of the project and commit the firm to a particular course
of action over a relatively long time horizon. As such, they are costly and difficult
to reverse, both because of: (1) their large cost; (2) the fact that they involve fixed
assets, which cannot be liquidated easily.
9-2. The criticisms of using the payback period as a capital budgeting technique are:
(1) It ignores the timing of the flows that occur during the payback period.
(2) It ignores all flows occurring after the payback period.
The advantages associated with the payback period are:
(1) It deals with cash flows rather than accounting profits and therefore focuses
on the true timing of the project's benefits and costs.
(2) It is easy to calculate and understand.
(3) It can be used as a rough screening device, eliminating projects whose returns
do not materialize until later years.
These final two advantages are the major reasons why it is used frequently.
9-3. Yes. The payback period eliminates projects whose returns do not materialize until
later years and thus emphasizes the earliest returns, which in a country experiencing
frequent expropriations would certainly have the most amount of uncertainty
surrounding them. In this case, the payback period could be used as a rough
screening device to filter out those riskier projects, which have long lives.
9-4. The three discounted cash flow capital budgeting criteria are the net present value,
the profitability index, and the internal rate of return. The net present value method
gives an absolute dollar value for a project by taking the present value of the benefits
and subtracting out the present value of the costs. The profitability index compares
these benefits and costs through division and comes up with a measure of the
project's relative value—a benefit/cost ratio. On the other hand, the internal rate of
return tells us the rate of return that the project earns. In the capital budgeting area,
these methods generally give us the same accept-reject decision on projects but many
times rank them differently. As such, they have the same general advantages and
disadvantages, although the calculations associated with the internal rate of return
method can become quite tedious. The advantages associated with these discounted
cash flow methods are:
(1) They deal with cash flows rather than accounting profits.
(2) They recognize the time value of money.
(3) They are consistent with the firm's goal of shareholder wealth maximization.
9.5. The advantage of using the MIRR as opposed to the IRR technique is that the MIRR
technique allows the decision maker to directly input the reinvestment rate
assumption. With the IRR method it is implicitly assumed that cash flows over the
life of the project are reinvested at the IRR

219
 SOLUTIONS TO
END-OF-CHAPTER PROBLEMS

Solutions to Problem Set A

9-1A. (a) IO = FCFt [PVIFIRR%,t yrs]

$10,000 = $17,182 [PVIFIRR%,8 yrs]

0.582 = PVIFIRR%,8 yrs

Thus, IRR = 7%
(b) $10,000 = $48,077 [PVIFIRR%,10 yrs]

0.208 = PVIFIRR%,10 yrs

Thus, IRR = 17%
(c) $10,000 = $114,943 [PVIFIRR%,20 yrs]
0.087 = PVIFIRR%,20 yrs

Thus, IRR = 13%

(d) $10,000 = $13,680 [PVIFIRR%,3 yrs]

.731 = PVIFIRR%,3 yrs

Thus, IRR = 11%
9-2A. (a) I0 = FCFt [PVIFAIRR%,t yrs]
$10,000 = $1,993 [PVIFAIRR%,10 yrs]

5.018 = PVIFAIRR%,10 yrs

Thus, IRR = 15%
(b) $10,000 = $2,054 [PVIFAIRR%,20 yrs]
4.869 = PVIFAIRR%,20 yrs

Thus, IRR = 20%

(c) $10,000 = $1,193 [PVIFAIRR%,12 yrs]

8.382 = PVIFAIRR%,12 yrs

Thus, IRR = 6%
(d) $10,000 = $2,843 [PVIFAIRR%,5 yrs]
3.517 = PVIFAIRR%,5 yrs

Thus, IRR = 13%

220
 $2,000 $5,000 $8,000
9-3A. (a) $10,000 = + 2 +
(1  IRR)1 (1  IRR) (1  IRR)3

Try 18%:
$10,000 = $2,000(0.847) + $5,000 (0.718) + $8,000 (0.609)
= $1,694 + $3,590 + $4,872
= $10,156
Try 19%
$10,000 = $2,000 (0.840) + $5,000 (0.706) + $8,000 (0.593)
= $1,680 + $3,530 + $4,744
= $9,954
Thus, IRR = approximately 19%
$8,000 $5,000 $2,000
(b) $10,000 = 1 + 2 +
(1  IRR) (1  IRR) (1  IRR)3

Try 30%
$10,000 = $8,000 (0.769) + $5,000 (0.592) + $2,000 (0.455)
= $6,152 + $2,960 + $910
= $10,022
Try 31%:
$10,000 = $8,000 (0.763) + $5,000 (0.583) + $2,000 (0.445)
= $6,104 + $2,915 + $890
= $9,909
Thus, IRR = approximately 30%
5 $2,000 $5,000
(c) $10,000 =  +
t 1 (1  IRR) t (1  IRR )6

Try 11%
$10,000 = $2,000 (3.696) + $5,000 (0.535)
= $7,392 + $2,675
= $10,067
Try 12%
$10,000 = $2,000 (3.605) + $5,000 (0.507)
= $7,210 + $2,535
= $9,745
Thus, IRR = approximately 11%

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 6 $450,000
9-4A. (a) NPV =  - $1,950,000
t 1 (1  .09) t
= $450,000 (4.486) - $1,950,000
= $2,018,700 - $1,950,000 = $68,700
$2,018,700
(b) PI =
$1,950,000

= 1.0352
(c) $1,950,000 = $450,000 [PVIFAIRR%,6 yrs]

4.333 = PVIFAIRR%,6 yrs

IRR = about 10% (10.1725%)

(d) Yes, the project should be accepted.
9-5A. (a) Payback Period = $80,000/$20,000 = 4 years
Discounted Payback Period Calculations:

Cumulative
Undiscounted Discounted Discounted
Year Cash Flows PVIF10%,n Cash Flows Cash Flows

0 -$80,000 1.000 -$80,000 -$80,000

1 20,000 .909 18,180 -61,820
2 20,000 .826 16,520 -45,300
3 20,000 .751 15,020 -30,280
4 20,000 .683 13,660 -16,620
5 20,000 .621 12,420 -4,200
6 20,000 .564 11,280 7,080

Discounted Payback Period = 5.0 + 4,200/11,280 = 5.37 years.

6 $20,000
(b) NPV =  - $80,000
t 1 (1  .10) t
= $20,000 (4.355) - $80,000
= $87,100 - $80,000 = $7,100

222
 $87,100
(c) PI =
$80,000

= 1.0888
(d) $80,000 = $20,000 [PVIFAIRR%,6 yrs]

4.000 = PVIFAIRR%,6 yrs

IRR = about 13% (12.978%)

6 $12,000
9-6A. (a) NPVA =  - $50,000
t 1 (1  .12) t
= $12,000 (4.111) - $50,000
= $49,332 - $50,000 = -$668
6 $13,000
NPVB =  - $70,000
t 1 (1  .12) t
= $13,000 (4.111) - $70,000
= $53,443 - $70,000 = -$16,557
$49,332
(b) PIA =
$50,000

= 0.9866
$53,443
PIB =
$70,000

= 0.7635
(c) $50,000 = $12,000 [PVIFAIRR%,6 yrs]

4.1667 = PVIFAIRR%,6 yrs

IRRA = 11.53%
$70,000 = $13,000 [PVIFAIRR%,6 yrs]

5.3846 = PVIFAIRR%,6 yrs

IRRB = 3.18%
Neither project should be accepted.

223
9-7A. (a) Project A:
Payback Period = 2 years + $100/$200 = 2.5 years
Project A:
Discounted Payback Period Calculations:

Cumulative
Undiscounted Discounted Discounted
Year Cash Flows PVIF10%,n Cash Flows Cash Flows

0 -$1,000 1.000 -$1,000 -$1,000

1 600 .909 545 -455
2 300 .826 248 -207
3 200 .751 150 -57
4 100 .683 68 11
5 500 .621 311 322

Discounted Payback Period = 3.0 + 57/68 = 3.84 years.

Project B:
Payback Period = 2 years + $2,000/$3,000 = 2.67 years
Project B:
Discounted Payback Period Calculations:

Cumulative
Undiscounted Discounted Discounted
Year Cash Flows PVIF10%,n Cash Flows Cash Flows

0 -$10,000 1.000 -$10,000 -$10,000

1 5,000 .909 4,545 -5,455
2 3,000 .826 2,478 -2,977
3 3,000 .751 2,253 -724
4 3,000 .683 2,049 1,325
5 3,000 .621 1,863 3,188

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 Discounted Payback Period = 3.0 + 724/2,049 = 3.35 years.
Project C:
Payback Period = 3 years + $1,000/$2,000 = 3.5 years
Project C:
Discounted Payback Period Calculations:
Cumulative
Undiscounted Discounted Discounted
Year Cash Flows PVIF10%,n Cash Flows Cash Flows

0 -$5,000 1.000 -$5,000 -$5,000

1 1,000 .909 909 -4,091
2 1,000 .826 826 -3,265
3 2,000 .751 1,502 -1,763
4 2,000 .683 1,366 -397
5 2,000 .621 1,242 845

Discounted Payback Period = 4.0 + 397/1,242 = 4.32 years.

8 $1,000,000
9-8A. NPV9% =  - $5,000,000
t 1 (1  .09) t
= $1,000,000 (5.535) - $5,000,000
= $5,535,000 - $5,000,000 = $535,000
8 $1,000,000
NPV11% =  - $5,000,000
t 1 (1  .11) t
= $1,000,000 (5.146) - $5,000,000
= $5,146,000 - $5,000,000 = $146,000
8 $1,000,000
NPV13% =  - $5,000,000
t  1 (1  .13)t

= $1,000,000 (4.799) - $5,000,000

= $4,799,000 - $5,000,000 = -$201,000
8 $1,000,000
NPV15% =  - $5,000,000
t 1 (1  .15) t
= $1,000,000 (4.487) - $5,000,000
= $4,487,000 - $5,000,000 = -$513,000

225
9-9A. Project A:
$10,000 $15,000 $20,000
$50,000 = + 2 +
(1  IRR A ) 1
(1  IRR A ) (1  IRR A )3
$25,000 $30,000
+ 4 +
(1  IRR A ) (1  IRR A )5
Try 23%
$50,000 = $10,000(.813) + $15,000(.661) + $20,000(.537)
+ $25,000(.437) + $30,000(.355)
= $8,130 + $9,915 + $10,740 + $10,925 + $10,650
= $50,360
Try 24%
$50,000 = $10,000(.806) + $15,000(.650) +$20,000(.524)
+ $25,000(.423) + $30,000(.341)
= $8,060 + $9,750 + $10,480 + $10,575 + $10,230
= $49,095
Thus, IRR = just over 23%
Project B:
$100,000 = $25,000 [PVIFAIRR%,5 yrs]

4.00 = PVIFAIRR%,5 yrs

Thus, IRR = 8%
Project C:
$450,000 = $200,000 [PVIFAIRR%,3 yrs]

2.25 = PVIFAIRR%,3 yrs

Thus, IRR = 16%

10 $18,000
9-10A. (a) NPV =  - $100,000
t 1 (1  .10) t
= $18,000(6.145) - $100,000
= $110,610 - $100,000
= $10,610

226
 10 $18,000
(b) NPV =  - $100,000
t 1 (1  .15) t
= $18,000(5.019) - $100,000
= $90,342 - $100,000
= -$9,658
(c) If the required rate of return is 10% the project is acceptable as in part (a).
(d) $100,000 = $18,000 [PVIFAIRR%,10 yrs]

5.5556 = PVIFAIRR%,10 yrs

IRR = Between 12% and 13% (12.41%)

n
n ACOFt  ACIFt (1  k) n  t
9-11A. a)  = t0
t0 (1  k) t
(1  MIRR)n
$3,000,000(FVIFA10%10years )
$10,000,000 =
(1  MIRR)10
$3,000,000(15.937)
$10,000,000 =
(1  MIRR )10
$47,811,000
$10,000,000 =
(1  MIRR )10

MIRR = 16.9375%
$3,000,000(FVIFA12%10years )
b) $10,000,000 =
(1  MIRR)10
$3,000,000(17.549)
$10,000,000 =
(1  MIRR )10
$52,647,000
$10,000,000 =
(1  MIRR )10

MIRR = 18.0694%

227
 $3,000,000( FVIFA14%10 years )
c) $10,000,000 =
(1  MIRR )10
$3,000,000(19.337)
$10,000,000 =
(1  MIRR )10
$58,011,000
$10,000,000 =
(1  MIRR )10

MIRR = 19.2207%

SOLUTION TO INTEGRATIVE PROBLEM

1. Capital budgeting decisions involve investments requiring rather large cash outlays
at the beginning of the life of the project and commit the firm to a particular course
of action over a relatively long time horizon. As such, they are both costly and
difficult to reverse, both because of: (1) their large cost; (2) the fact that they
involve fixed assets which cannot be liquidated easily.
2. Axiom 5: The Curse of Competitive Markets—Why It's Hard to Find Exceptionally
Profitable Projects deals with the problems associated with finding profitable
projects. When we introduced that axiom we stated that exceptionally successful
investments involve the reduction of competition by creating barriers to entry either
through product differentiation or cost advantages. In effect, without barriers to
entry, whenever extremely profitable projects are found competition rushes in,
driving prices and profits down unless there is some barrier to entry.
20,000
3. Payback periodA = 3 years + years = 3.4years
50,000
110 ,000
Payback PeriodB = years = 2.75 years
40,000
Project B should be accepted while project A should be rejected.
4. The disadvantages of the payback period are: 1)ignores the time value of money,
2)ignores cash flows occurring after the payback period, 3)selection of the maximum
acceptable payback period is arbitrary.

228
5. Discounted Payback Period Calculations, Project A:

Cumulative
Undiscounted Discounted Discounted
Year Cash Flows PVIF12%,n Cash Flows Cash Flows

0 -$110,000 1.000 -$110,000 -$110,000

1 20,000 .893 17,860 -92,140
2 30,000 .797 23,910 -68,230
3 40,000 .712 28,480 -39,750
4 50,000 .636 31,800 -7,950
5 70,000 .567 39,690 31,740

Discounted Payback Period = 4.0 + 7,950/39,690 = 4.20 years.

Discounted Payback Period Calculations, Project B:

Cumulative
Undiscounted Discounted Discounted
Year Cash Flows PVIF12%,n Cash Flows Cash Flows

0 -$110,000 1.000 -$110,000 -$110,000

1 40,000 .893 35,720 -74,280
2 40,000 .797 31,880 -42,400
3 40,000 .712 28,480 -13,920
4 40,000 .636 25,440 11,520
5 40,000 .567 22,680 34,200

Discounted Payback Period = 3.0 + 13,920/25,440 = 3.55 years.

Using the discounted payback period method and a 3 year maximum acceptable
project hurtle, neither project should be accepted.

6. The major problem with the discounted payback period comes in setting the firm's
maximum desired discounted payback period. This is an arbitrary decision that
affects which projects are accepted and which ones are rejected. Thus, while the
discounted payback period is superior to the traditional payback period, in that it
accounts for the time value of money in its calculations, its use should be limited due
to the problem encountered in setting the maximum desired payback period. In
effect, neither method should be used.

229
 n
FCFt
7. NPVA =  (1  k) t
- IO
t 1

= $20,000(PVIF12%, 1 year) + $30,000 (PVIF12%, 2 years)

+ $40,000(PVIF12%, 3 years) + $50,000 (PVIF12%, 4 years)
+ $70,000(PVIF12, 5 years) - $110,000
= $20,000(.893) + $30,000 (.797) + $40,000 (.712) + $50,000
(.636) + $70,000 (.567) - $110,000
= $17,860 + $23,910 + $28,480 + $31,800 + $39,690 - $110,000
= $141,740-$110,000
= $31,740
NPVB = $40,000(PVIFA12%, 5 years) - $110,000
= $40,000(3.605) - $110,000
= $144,200-$110,000
= $34,200
Both projects should be accepted

8. The net present value technique discounts all the benefits and costs in terms of cash
flows back to the present and determines the difference. If the present value of the
benefits outweighs the present value of the costs the project is accepted if not, it is
rejected.
 n 


 FCFt 

t 1
9. PIA =  t 
 (1  k) 
 
 
IO
$141,740
=
$110,000

= 1.2885
$144,200
PIB =
$110,000

= 1.3109
Both projects should be accepted
10. The net present value and the profitability index always give the same accept reject
decision. When the present value of the benefits outweighs the present value of the
costs the profitability index is greater than one and the net present value is positive.
In that case, the project should be accepted. If the present value of the benefits is
less than the present value of the costs then the profitability index will be less than
one and the net present value will be negative and the project will be rejected.

230
11. For both projects A and B all of the costs are already in present dollars and, as such,
will not be affected by any change in the required rate of return or discount rate. All
the benefits for these projects are in the future and thus when there is a change in the
required rate of return or discount rate their present value will change. If the
required rate of return increased the present value of the benefits would decline
which would in turn result in a decrease in both the net present value and the
profitability index for each project.
12. IRRA = 20.9698%
IRRB = 23.9193%
13. The required rate of return does not change the internal rate of return for a project,
but it does affect whether a project is accepted or rejected. The required rate of
return is the hurdle rate that the project's IRR must exceed in order to accept the
project.
14. The net present value assumes that all cash flows over the life of the project are
reinvested at the required rate of return, while the internal rate of return implicitly
assumes that all cash flows over the life of the project are reinvested over the
remainder of the project's life at the IRR. The net present value method makes the
most acceptable, and conservative assumption and thus is preferred.
15. Project A:
n
n ACOFt  ACIFt (1  k) n  t
 = t 0
t 0 (1  k) t
(1  MIRR A ) n

$20,000(FVIF12% , 4 years)  $30,000(FVIF12% , 3 years)

 $40,000(FVIF12% , 2 years)  $50,000(FVIF12% , 1 year)
$110,000 =  $70,000
(1  MIRR A )5

$20,000(1.574)  $30,000(1.405)
$110,000 =  $40,000(1.254)  $50,000(1.120)  $70,000
(1  MIRR A )5

$110,000 =
$31,480  $42,150  $50,160  $56,000  $70,000
(1  MIRR A )5
$249,790
$110,000 =
(1  MIRR A )5
MIRRA = 17.8247%

Project B:

231
 $40,000(FVIFA12%,5years )
$110,000 =
(1  MIRR B )5

$40,000(6.353)
$110,000 =
(1  MIRR B )5

$254,120
$110,000 =
(1  MIRR B )5

MIRRB = 18.2304%

Solutions to Problem Set B

9-1B. (a) IO = FCFt [PVIFIRR%,t yrs]

$10,000 = $19,926 [PVIFIRR%,8 yrs]

0.502 = PVIFIRR%,8 yrs

Thus, IRR = 9%
(b) $10,000 = $20,122 [PVIFIRR%,12 yrs]

0.497 = PVIFIRR%,12 yrs

Thus, IRR = 6%
(c) $10,000 = $121,000 [PVIFIRR%,22 yrs]

0.083 = PVIFIRR%,22 yrs

Thus, IRR = 12%

(d) $10,000 = $19,254 [PVIFIRR%,5 yrs]

.519 = PVIFIRR%,5 yrs

Thus, IRR = 14%

9-2B. (a) IO = FCFt [PVIFAIRR%,t yrs]

$10,000 = $2,146 [PVIFAIRR%,10 yrs]

4.659 = PVIFAIRR%,10 yrs

Thus, IRR = 17%

(b) $10,000 = $1,960 [PVIFAIRR%,20 yrs]

5.102 = PVIFAIRR%,20 yrs

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 Thus, IRR = 19%
(c) $10,000 = $1,396 [PVIFAIRR%,12 yrs]

7.163 = PVIFAIRR%,12 yrs]

Thus, IRR = 9%
(d) $10,000 = $3,197 [PVIFAIRR%,5 yrs]

3.128 = PVIFAIRR%,5 yrs

Thus, IRR = 18%

$3,000 $5,000 $7,500
9-3B. (a) $10,000 = + 2 +
(1  IRR) 1
(1  IRR) (1  IRR)3

Try 21%:
$10,000 = $3,000(0.826) + $5,000 (0.683) + $7,500 (0.564)
= $2,478+ $3,415 + $4,230
= $10,123
Try 22%
$10,000 = $3,000 (0.820) + $5,000 (0.672) + $7,500 (0.551)
= $2,460 + $3,360 + $4,132.50
= $9,952.50
Thus, IRR = approximately 22%
$9,000 $6,000 $2,000
(b) $12,000 = 1 + 2 +
(1  IRR) (1  IRR) (1  IRR)3

Try 25%
$12,000 = $9,000 (0.800) + $6,000 (0.640) + $2,000 (0.512)
= $7,200 + $3,840 + $1,024
= $12,064
Try 26%:
$12,000 = $9,000 (0.794) + $6,000 (0.630) + $2,000 (0.500)
= $7,146 + $3,780 + $1,000
= $11,926
Thus, IRR = approximately 25% - 26%
5 $5,000
$2,000
(c) $8,000 =  (1  IRR) t
+
(1  IRR)6
t 1

Try 18%
$8,000 = $2,000 (3.127) + $5,000 (0.370)

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 = $6,254 + $1,850
= $8,104
Try 19%
$8,000 = $2,000 (3.058) + $5,000 (0.352)
= $6,116 + $1,760
= $7,876
Thus, IRR = approximately 18%-19%
6 $750,000
9-4B. (a) NPV =  - $2,500,000
t 1 (1  .11) t
= $750,000 (4.231) - $2,500,000
= $3,173,250 - $2,500,000
= $673,250
$3,173,250
(b) PI =
$2,500,000

= 1.2693
(c) $2,500,000 = $750,000 [PVIFAIRR%,6 yrs]

3.333 = PVIFAIRR%,6 yrs

IRR = about 20% (19.90%)

(d) Yes, the project should be accepted.

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9-5B. (a) Payback Period = $160,000/$40,000 = 4 years
Discounted Payback Period Calculations:

Cumulative
Undiscounted Discounted Discounted
Year Cash Flows PVIF10%,n Cash Flows Cash Flows

0 -$160,000 1.000 -$160,000 -$160,000

1 40,000 .909 36,360 -123,640
2 40,000 .826 33,040 -90,600
3 40,000 .751 30,040 -60,560
4 40,000 .683 27,320 -33,240
5 40,000 .621 24,840 -8,400
6 40,000 .564 22,560 14,160

Discounted Payback Period = 5.0 + 8,400/22,560 = 5.37 years.

6 $40,000
(b) NPV =  - $160,000
t 1 (1  .10) t
= $40,000 (4.355) - $160,000
= $174,200 - $160,000 = $14,200
$174,200
(c) PI =
$160,000

= 1.0888
(d) $160,000 = $40,000 [PVIFAIRR%,6 yrs]

4.000 = PVIFAIRR%,6 yrs

IRR = about 13% (12.978%)

6 $12,000
9-6B. (a) NPVA =  - $45,000
t 1 (1  .12) t
= $12,000 (4.111) - $45,000
= $49,332 - $45,000 = $4,332
6 $14,000
NPVB =  - $70,000
t 1 (1  .12) t
= $14,000 (4.111) - $70,000
= $57,554 - $70,000 = -$12,446
$49,332
(b) PIA =
$45,000

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 = 1.0963
$57,332
PIB =
$70,000

= 0.8190
(c) $45,000 = $12,000 [PVIFAIRR%,6 yrs]

3.75 = PVIFAIRR%,6 yrs

IRRA = 15.34%
$70,000 = $14,000 [PVIFAIRR%,6 yrs]

5.0000 = PVIFAIRR%,6 yrs

IRRB = 5.47%
Project A should be accepted.
9-7B. (a) Project A:
Payback Period = 2 years
Project B:
Payback Period = 2 years + $1,000/$3,000 = 2.33 years
Project C:
Payback Period = 3 years + $1,000/$2,000 = 3.5 years
8 $2,500,000
9-8B. NPV9% =  - $10,000,000
t 1 (1  .09) t
= $2,500,000 (5.535) - $10,000,000
= $13,837,500 - $10,000,000 = $3,837,500
8 $2,500,000
NPV11% =  - $10,000,000
t 1 (1  .11) t
= $2,500,000 (5.146) - $10,000,000
= $12,865,000 - $10,000,000 = $2,865,000
8 $2,500,000
NPV13% =  - $10,000,000
t 1 (1  .13) t
= $2,500,000 (4.799) - $10,000,000
= $11,997,500 - $10,000,000 = $1,997,500
8 $2,500,000
NPV15% =  - $10,000,000
t 1 (1  .15) t
= $2,500,000 (4.487) - $10,000,000

236
 = $11,217,500 - $10,000,000 = $1,217,500
9-9B. Project A:
$10,000 $10,000 $30,000
$75,000 = + 2 +
(1  IRR A )1 (1  IRR A ) (1  IRR A )3
$25,000 $30,000
+ 4 +
(1  IRR A ) (1  IRR A )5
Try 10%
$75,000 = $10,000(.909) + $10,000(.826) + $30,000(.751)
+ $25,000(.683) + $30,000(.621)
= $9,090 + $8,260 + $22,530 + $17,075 + $18,630
= $75,585
Try 11%
$75,000 = $10,000(.901) + $10,000(.812) +$30,000(.731)
+ $25,000(.659) + $30,000(.593)
= $9,010 + $8,120 + $21,930+ $16,475 + $17,790
= $73,325
Thus, IRR = just over 10%
Project B:
$95,000 = $25,000 [PVIFAIRR%,5 yrs]

3.80 = PVIFAIRR%,5 yrs

Thus, IRR = just below 10%

Project C:
$395,000 = $150,000 [PVIFAIRR%,3 yrs]

2.633 = PVIFAIRR%,3 yrs

Thus, IRR = just below 7%

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 10 $25,000
9-10B. (a) NPV =  - $150,000
t 1 (1  .09)t
= $25,000(6.418) - $150,000
= $160,450 - $150,000
= $10,450
10 $25,000
(b) NPV =  - $150,000
t 1 (1  .15) t
= $25,000(5.019) - $150,000
= $125,475 - $150,000
= -$24,525
(c) If the required rate of return is 9% the project is acceptable in part (a). It
should rejected in part (b) with a negative NPV.
(d) $150,000 = $25,000 [PVIFAIRR%,10 yrs]

6.000 = PVIFAIRR%,10 yrs

IRR = Between 10% and 11% (10.558%)

9-11B.
n
n -t
n ACOFt  ACIFt (1  k)
(a)  = t 0
t 0 (1  k) t
(1  MIRR) n
$2,000,000(FVIFA10%,8years )
$8,000,000 =
(1  MIRR)8
$2,000,000(11.436)
$8,000,000 =
(1  MIRR)8
$22,872000
$8,000,000 =
(1  MIRR)8

MIRR = 14.0320%
$2,000,000(FVIFA12%,8years )
b) $8,000,000 =
(1  MIRR)8
$2,000,000(12.300)
$8,000,000 =
(1  MIRR)8
$24,600,000
$8,000,000 =
(1  MIRR)8

MIRR = 15.0749%

238
 $2,000,000(FVIFA14%,8years )
c) $8,000,000 =
(1  MIRR)8
$2,000,000(13.233)
$8,000,000 =
(1  MIRR)8
$26,466,000
$8,000,000 =
(1  MIRR)8

MIRR = 16.1312%

FORD'S PINTO
(Ethics in Capital Budgeting)

OBJECTIVE: To force the students to recognize the role ethical behavior plays in all
areas of Finance.

DEGREE OF DIFFICULTY: Easy

Case Solution:

With ethics cases there are no right or wrong answers - just opinions. Try to bring
out as many opinions as possible without being judgmental.

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