Chapter 12

Chapter12
RiskandRefinementsinCapitalBudgeting
Instructors Resources
Overview
Chapters10and11developedthemajordecisionmakingaspectsofcapitalbudgeting.Cashflowsand
budgetingmodelshavebeenintegratedanddiscussedinprovidingtheprinciplesofcapitalbudgeting.
However,therearemorecomplexissuesbeyondthosepresented.Chapter12expandscapitalbudgeting
toconsiderriskwithsuchmethodsasscenarioanalysisandsimulation.Capitalbudgetingtechniques
usedtoevaluateinternationalprojects,aswellasthespecialrisksmultinationalcompaniesface,arealso
presented.Additionally,twobasicriskadjustmenttechniquesareexamined:certaintyequivalentsand
riskadjusteddiscountrates.Thechapterpresentsstudentswithseveralexamplesoftheapplicationofrisk
basedrefinementswhencapitalbudgetingintheirprofessionalandpersonallife.
Suggested Answer to Opener in Review Question

ThechapteropenerandtheFocusonEthicsboxinthischapterdescribedsomeoftheconsequences
oftheaccidentatBPsDeepwaterHorizonoilrig.ItisplausiblethatengineersandanalystsatBP
couldhaveimaginedaworstcasescenarioinwhichamajorspilloccurredatoneofthefirms
offshorerigs.HowmightathoroughscenarioanalysishaveinfluencedBPsoffshoredrilling
activities?
AnincreaseinthecostofcapitalmeansthatthemarketisdiscountingBPscashflowsatahigherrate.
ThatincludescashflowsfromBPsexistinginvestmentsaswellasinvestmentsthatthemarkethad
anticipatedthatBPwouldmakeinthefuture(andhencehadalreadybeenincorporated,atleastpartially,
intoBPsstockprice).Wehaveseenthatanincreaseinthediscountrateleadstoadeclineinthepresent
valueofacashflowstream,soitislogicalthatajumpinBPscostsofcapitalwouldbeassociatedwitha
majordropinthefirmsoverallvalue.
IfBPanalystshadimaginedthecostsofamajoroilspillasaworstcasescenario,itseemslikelythatBP
wouldhavetakenwhateverstepswerenecessarytopreventsuchanaccident.Thecashinflowsgenerated
byanoffshoreplatformareswampedbythecostsofamajorspill.Notallaccidentsarepreventable,of
course,butthefactthatBPengineerscouldnotquicklystoptheflowofoilintotheGulfofMexico
suggeststhatanaccidentofthetypethatoccurredontheoilrighadnotbeenplannedforinadvance.
2012PearsonEducation,Inc.PublishingasPrenticeHall
Chapter12RiskandRefinementsinCapitalBudgeting250
Answers to Review Questions

1. There is usually a significant degree of uncertainty associated with capital budgeting projects. There is the usual
business risk along with the fact that future cash flows are an estimate and do not represent exact values. The
uncertainly of each project cash flow stream will be different and thus each project has its own unique risk. This
uncertainty exists for both independent and mutually exclusive projects. The risk associated with any single
project has the capability to change the entire risk of the firm. The firms assets are like a portfolio of assets. If
an accepted capital budgeting project has a risk different from the average risk of the assets in the firm, it will
cause a shift in the overall risk of the firm.
2. Risk, in terms of cash inflows from a project, is the variability of expected cash flows, hence the expected
returns, of the given project. The breakeven cash inflow the level of cash inflow necessary in order for the
project to be acceptable may be compared with the probability of that inflow occurring. When comparing two
projects with the same breakeven cash inflows, the project with the higher probability of occurrence is less
risky.
3. a.
Scenario analysis uses a number of possible inputs (cash inflows) to assess their impact on
the firms net present value (NPV) return. Scenario analysis can be used to evaluate the impact on return of
simultaneous changes in a number of variables, such as cash inflows, cash outflows, and the cost of capital,
resulting from differing assumptions relative to economic and competitive conditions. In capital budgeting,
the NPVs are frequently estimated for the pessimistic, most likely, and optimistic cash flow estimates. By
subtracting the pessimistic outcome NPV from
the optimistic outcome NPV, a range of NPVs can be determined.
b. Simulationisastatisticallybasedapproachusingrandomnumberstosimulatevariouscashflows
associatedwiththeproject,calculatingtheNPVorinternalrateofreturn(IRR)onthebasisof
thesecashflows,andthendevelopingaprobabilitydistributionofeachprojectsrateofreturns
basedonNPVorIRRcriterion.
4. a.
Multinational companies (MNCs) must consider the effect of exchange rate risk, the risk that the exchange
rate between the dollar and the currency in which the projects cash flows are denominated will reduce the
projects future cash flows. If the value of the dollar depreciates relative to that currency, the dollar value of
the projects cash flows will increase as a result. Firms can use hedging to protect themselves against this
risk in the short term; for the long term, financing the project using local currency can minimize this risk.
b. Politicalrisk,theriskthataforeigngovernmentsactionswilladverselyaffecttheproject,makes
internationalprojectsparticularlyrisky,becauseitcannotbepredictedinadvance.Totakethis
riskintoaccount,managersshouldeitheradjustexpectedcashflowsoruseriskadjusteddiscount
rateswhenperformingthecapitalbudgetinganalysis.Adjustmentofcashflowsisthepreferred
method.
c.
Taxlawsdifferfromcountrytocountry.Becauseonlyaftertaxcashflowsarerelevantforcapital
budgetingdecisions,managersmustaccountforalltaxespaidtoforeigngovernmentsandconsider
theeffectofanyforeigntaxpaymentsonthefirmsU.S.taxliability.
d. Transferpricingreferstothepriceschargedbyacorporationssubsidiariesforgoodsandservices
tradedbetweenthem;thepricesarenotsetbytheopenmarket.Intermsofcapitalbudgeting
decisions,managersshouldbesurethattransferpricesaccuratelyreflectactualcostsand
incrementalcashflows.
e.
MNCscannotevaluateinternationalcapitalprojectsfromonlyafinancialperspective.The
strategicviewpointoftenisthedeterminingfactorindecidingwhetherornottoundertakea
project.Infact,aprojectthatislessacceptablethananotheronapurelyfinancialbasismay
bechosenforstrategicreasons.SomereasonsforMNCforeigninvestmentincludecontinued
marketaccess,theabilitytocompetewithlocalcompanies,politicaland/orsocialreasons
(forexample,gainingfavorabletaxtreatmentinexchangeforcreatingnewjobsinacountry),
andachievementofaparticularcorporateobjectivesuchasobtainingareliablesourceofraw
materials.
5. Risk-adjusted discount rates (RADRs) reflect the return that must be earned on a given project in order to
adequately compensate the firms owners. The relationship between RADRs and the capital asset pricing model
252Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition
(CAPM) is a purely theoretical concept. The expression used to value the expected rate of return of a security ki
(ki RF [b (km RF)]) is rewritten substituting an asset for a security. Because real corporate assets are not
traded in efficient markets and estimation of a market return, km, for a portfolio of such assets would be
difficult, the CAPM is not used for real assets.
6. A firm whose stock is actively traded in security markets generally does not increase in value through
diversification. Investors themselves can more efficiently diversify their portfolio by holding a variety of stocks.
Since a firm is not rewarded for diversification, the risk of a capital budgeting project should be considered
independently rather than in terms of their impact on the total portfolio of assets. In practice, management
usually follows this approach and evaluates projects based on their total risk.
7. RADRs are most often used in practice for two reasons: (1) financial decision makers prefer using rate of
return-based criteria, and (2) they are easy to estimate and apply. In practice, risk is subjectively categorized
into classes, each having a RADR assigned to it. Each project is then subjectively placed in the appropriate risk
class.
8. A comparison of NPVs of unequal-lived mutually exclusive projects is inappropriate because it may lead to an
incorrect choice of projects. The annualized net present value (ANPV) converts the NPV
of unequal-lived projects into an annual amount that can be used to select the best project.
9. Real options are opportunities embedded in real assets that are part of the capital budgeting process. Managers
have the option of implementing some of these opportunities to alter the cash flow and risk of a given project.
Examples of real options include:
Abandonmentthe option to abandon or terminate a project prior to the end of its planned life.
Flexibilitythe ability to adopt a project that permits flexibility in the firms production process, such as being
able to reconfigure a machine to accept various types of inputs.
Growththe option to develop follow-on projects, expand markets, expand or retool plants, and so on, that
would not be possible without implementation of the project that is being evaluated.
Timingthe ability to determine the exact timing of when various action of the project will be undertaken.
10.
Strategic NPV incorporates the value of the real options associated with the project while traditional NPV
includes only the identifiable relevant cash flows. Using strategic NPV could alter the final accept/reject
decision. It is likely to lead to more accept decisions since the value of the options is added to the traditional
NPV, as shown in the following equation.
NPVstrategicNPVtraditionalValueofrealoptions
11.
Capital rationing is a situation where a firm has only a limited amount of funds available for capital
investments. In most cases, implementation of the acceptable projects would require more capital than is
available. Capital rationing is common for a firm, since unfortunately most firms do not have sufficient capital
available to invest in all acceptable projects. In theory, capital rationing should not exist because firms should
accept all projects with positive NPVs or IRRs greater than the cost of capital. However, most firms operate
with finite capital expenditure budgets and must select the best from all acceptable projects, taking into account
the amount of new financing required to fund these projects.
12. The IRR approach and the NPV approach to capital rationing both involve ranking projects on the basis of
IRRs. Using the IRR approach, a cut-off rate and a budget constraint are imposed. The NPV first ranks projects
by IRR and then takes into account the present value of the benefits from each project in order to determine the
combination with the highest overall net present value. The benefit of the NPV approach is that it guarantees a
maximum dollar return to the firm, whereas the IRR approach does not.
Suggested Answer to Focus on Practice Box: The Monte Carlo

Method: The Forecast Is for Less Uncertainty
AMonteCarlosimulationprogramrequirestheusertofirstbuildanExcelspreadsheetmodelthat
capturestheinputvariablesfortheproposedproject.Whatissuesandwhatbenefitscantheuser
derivefromthisprocess?
AgoodMonteCarlosimulationrequiresreasonablyaccurateestimatesofdata,includingprojectedsales
figures,productioncosts,associatedoverhead,marketingcosts,andothercostsrelatedtotheproject.
Gatheringthistypeofdatafornumerousprojectscanbeexpensiveintermsofemployeehours.However,
anysoundevaluationofaprojectwilleventuallyrequiresuchinformationgatheringbeforeadecisioncan
bemade.ThebenefitoftheMonteCarloprogramisthatitcanquicklyprovidearangeofprobableoutcomes
asthepotentialinputsarevaried.Forexample,ifthemarketingvariableisincreased,theeffectonpossible
salesoutcomecanbequicklydemonstrated.
Butevenbeyondthequickanalysisoftheeffectofchangingaprojectvariableisthattheneedforaccurate
andreasonableestimateswillforceprojectdeveloperstospendsometimeandefforttodeveloptheproper
dataforinputintotheMonteCarloprogram.Workingdiligentlytofindreliablecostestimatesandmarketing
estimatescanonlyenhancetheviabilityofaproposedprojectifitmeetsthecompanysselectioncriteria.
Suggested Answer to Focus on Ethics Box:

Ethics and the Cost of Capital
Istheultimategoalofthefirm,tomaximizethewealthoftheownersforwhomthefirmisbeing
operated,ethical?
Itisnotthegoalthatmakesmaximizationofshareholderwealthethicalorunethical,itisactionsofthe
financialmanagerinpursuitofthisgoalthatdictatesthelevelofethics.
Whymightethicalcompaniesbenefitfromalowercostofcapitalthanlessethicalcompanies?
Ifethicalbehaviorreducestheriskofinvestinginacompany(e.g.,reducesthevolatilityofthefirmscash
flows),ethicalcompaniesshouldbenefitmorefromalowercostofcapitalthanlessethicalcompanies.
Answers to Warm-Up Exercises

E12-1.
Sensitivity analysis
Answer: Usingthe12%costofcapitaltodiscountallofthecashflowsforeachscenariotoyieldthe
followingNPVs,resultinginaNPVrangeof$19,109.78:
Pessimistic
MostLikely
Optimistic
$3,283.48
$6,516.99
$15,826.30
E12-2.
Using IRR as selection criteria
Answer: Theminimumamountofannualcashinflowneededtoearn8%is$11,270.54
N5,I8%,PV$45,000
SolveforPMT$11,270.54
TheIRRoftheprojectis12.05%.
N5,PV$45,000,PMT$12,500
SolveforI$12.05%
TheprojectisacceptablesinceitsIRRexceedsthefirms8%costofcapital.Sincetherequired
cashflowismuchlessthantheanticipatedcashflow,onewouldexpecttheIRRtoexceedthe
requiredrateofreturn.
E12-3.
Risk-adjusted discount rates
Answer: ProjectSourdoughRADR7.0%
N7,I7%,PMT$5,500
SolveforPV$29,641.09
NPVPVnInitialinvestment
NPV$29,641.09$12,500
NPV$17,141.09
ProjectGreekSaladRADR8.0%
N7,I8%,PMT$4,000
NPVPVnInitialinvestment
NPV$20,825.48$7,500
NPV$13,325.48
YeastimeshouldselectProjectSourdough.
E12-4.
ANPV
Answer: YoumayuseafinancialcalculatortodeterminetheIRRofeachproject.Choosetheproject
withthehigherIRR.
ProjectM
Step1:
FindtheNPVoftheproject
NPVMKeystrokes
CF0$35,000,CF1$12,000,CF2$25,000,CF3$30,000
SetI8%
SolveforNPV$21,359.55
Step2:
FindtheANPV
N3,I8,PV$21,359.55
ProjectN
Step1:
FindtheNPVoftheproject
NPVMKeystrokes
CF0$55,000,CF1$18,000,CF2$15,000,CF3$25,000
CF4$10,000,CF5$8,000,CF6$5,000,CF7$5,000
SetI8%
Step2:
FindtheANPV
N7,I8,PV$13,235.82
BasedonANPV,youshouldadviseOutcast,Inc.tochooseProjectM.
E12-5.
NPV profiles
Answer: Theinvestmentopportunityschedule(IOS)inthisproblemdoesnotallowustodeterminethe
maximumNPVallowedbythebudgetconstraint.InordertodeterminewhethertheIOS
maximizestheNPVforLongchampsElectric,wewillneedtoknowtheNPVforeachofthe
sixprojects.However,itdoesappearlikelythatLongchampsElectricwillmaximizefirmvalue
byselectingProject4(IRR11%),Project2(IRR10%),andProject5(IRR9%).Thetotal
investmentinthesethreeprojectswillbe$135,000,leaving$15,000excesscashforfuture
investmentopportunities.
Solutions to Problems
P121. Recognizingrisk
LG1;Basic
a.andb.
Project
Risk
Reason
Low
Thecashflowsfromtheprojectcanbeeasilydeterminedsince
thisexpenditureconsistsstrictlyofoutflows.Theamountisalso
relativelysmall.
Medium
ThecompetitivenatureoftheindustrymakesitsothatCaradine
willneedtomakethisexpendituretoremaincompetitive.Therisk
isonlymoderatesincethefirmalreadyhasclientsinplacetouse
thenewtechnology.
Medium
Sincethefirmisonlypreparingaproposal,theircommitmentat
thistimeislow.However,the$450,000isalargesumofmoney
forthecompanyanditwillimmediatelybecomeasunkcost.
High
AlthoughthispurchaseisintheindustryinwhichCaradine
normallyoperates,theyareencounteringalargeamountofrisk.
Thelargeexpenditure,thecompetitivenessoftheindustry,andthe
politicalandexchangeriskofoperatinginaforeigncountryaddto
theuncertainty.
Note:Otheranswersarepossibledependingontheassumptionsastudentmaymake.Thereistoo
littleinformationgivenaboutthefirmandindustrytoestablishadefinitiveriskanalysis.
P122. Breakevencashflows
LG2;Intermediate
a.
N12,I14%,PV$35,000
b. N12,I10%,PV$35,000
Therequiredcashflowperyearwoulddecreaseby$1,047.27.
P123. Breakevencashinflowsandrisk
LG2;Intermediate
a.
ProjectX
ProjectY
N5,I15%,PMT$10,000
N5,I15%,PMT$15,000
SolveforPV33,521.55
NPV PVinitialinvestment
NPV PVinitialinvestment
NPV $33,521.55$30,000
NPV $50,282.33$40,000
NPV $3,521.55
NPV $10,282.33
b. ProjectX
c.
ProjectY
N5,I15%,PV$30,000
N5,I15%,PV$40,000
ProjectX
ProjectY
Probability60%
Probability25%
d. ProjectYismoreriskyandhasahigherpotentialNPV.ProjectXhaslessriskandlessreturn
whileProjectYhasmoreriskandmorereturn,thustheriskreturntradeoff.
e.
ChooseProjectXtominimizelosses;toachievehigherNPV,chooseProjectY.
P124. Basicscenarioanalysis
LG2;Intermediate
a.
RangeA$1,800$200$1,600 RangeB$1,100$900$200
b.
NPVs
Outcome
ProjectA
ProjectB
Pessimistic
$6,297.29
$337.79
Mostlikely
513.56
513.56
7,324.41
1,364.92
Optimistic
Range
c.
$13,621.70
$1,702.71
AlthoughthemostlikelyoutcomeisidenticalforProjectAandB,theNPVrangevaries
considerably.
d. Projectselectionwoulddependupontheriskdispositionofthemanagement.(Aismorerisky
thanBbutalsohasthepossibilityofagreaterreturn.)
P125. Scenarioanalysis
LG2;Intermediate
a.
RangeP$1,000$500$500
RangeQ$1,200$400$800
b.
NPVs
c.
Outcome
ProjectP
ProjectQ
Pessimistic
$72.28
$542.17
Mostlikely
1,608.43
1,608.43
Optimistic
3,144.57
4,373.48
RangeP$3,144.57$72.28$3,072.29
RangeQ$4,373.48($542.17)$4,915.65
Eachcomputerhasthesamemostlikelyresult.ComputerQhasbothagreaterpotentialloss
andagreaterpotentialreturn.Therefore,thedecisionwilldependontheriskdispositionof
management.
P126. PersonalFinance:Impactofinflationoninvestments
LG2;Easy
a.c.
Investment
Cash Flows
Year
Current
NPV (a)
Higher
Inflation
NPV (b)
Lower
Inflation
NPV (c)
(7,500)
(7,500)
(7,500)
(7,500)
2,000
1,878
1,860
1,896
2,000
1,763
1,731
1,797
2,000
1,656
1,610
1,703
1,500
1,166
1,123
1,211
1,500
1,095
1,045
1,148
$ 58
$ (131)
$ 254
Total NPV
d. AstheinflationraterisestheNPVofagivensetofcashflowsdeclines.
P127. Simulation
LG2;Intermediate
a.
OgdenCorporationcoulduseacomputersimulationtogeneratetherespectiveprofitability
distributionsthroughthegenerationofrandomnumbers.Bytyingvariouscashflowassumptions
togetherintoamathematicalmodelandrepeatingtheprocessnumeroustimes,aprobability
distributionofprojectreturnscanbedeveloped.Theprocessofgeneratingrandomnumbers
andusingtheprobabilitydistributionsforcashinflowsandoutflowsallowsvaluesforeach
ofthevariablestobedetermined.Theuseofthecomputeralsoallowsformoresophisticated
simulationusingcomponentsofcashinflowsandoutflows.Substitutionofthesevaluesinto
themathematicalmodelyieldstheNPV.Thekeyliesinformulatingamathematicalmodel
thattrulyreflectsexistingrelationships.
b. Theadvantagestocomputersimulationsincludethedecisionmakersabilitytoview
acontinuumofriskreturntradeoffsinsteadofasinglepointestimate.Thecomputer
simulation,however,isnotfeasibleforriskanalysis.
P128. RiskadjusteddiscountratesBasic
LG4;Intermediate
a.
ProjectE
N4,I15%,PMT$6,000
NPV$17,129.87$15,000
NPV$2,129.87
ProjectF
CF0$11,000,CF1$6,000,CF2$4,000,CF3$5,000,CF4$2,000
SetI15%
ProjectG
CF0$19,000,CF1$4,000,CF2$6,000,CF3$8,000,C44$12,000
SetI15%
ProjectE,withthehighestNPV,ispreferred.
b. RADRE0.10(1.80(0.150.10))0.19
RADRF0.10(1.00(0.150.10))0.15
RADRG0.10(0.60(0.150.10))0.13
c.
ProjectE
N4,I19%,PMT$6,000
NPV$15,831.51$15,000
NPV$831.51
ProjectF
Sameasinparta,$1,673.05
ProjectG
CF0$19,000,CF1$4,000,CF2$6,000,CF3$8,000,CF4$12,000
SetI13%
Rank
Project
d. Afteradjustingthediscountrate,eventhoughallprojectsarestillacceptable,theranking
changes.ProjectGhasthehighestNPVandshouldbechosen.
P129. RiskadjusteddiscountratesTabular
LG4;Intermediate
a.
ProjectA
N5,I8%,PMT$7,000
NPV$27,948.97$20,000
NPV$7,948.97
ProjectB
N5,I14%,PMT$10,000
NPV$34,330.81$30,000
NPV$4,330.81
ProjectA,withthehigherNPV,shouldbechosen.
b. ProjectAispreferabletoProjectB,sincetheNPVofAisgreaterthantheNPVofB.
P1210. PersonalFinance:Mutuallyexclusiveinvestmentandrisk
LG4;Intermediate
a.
N6,I8.5%,PMT$3,000
SolveforPV13,660.76
NPV$13,660.76$10,000
NPV$3,660.76
b. N6,I10.5%,PMT$3,800
NPV$16,31.28$12,000
NPV$4,310.28
c.
UsingNPVasherguide,Larashouldselectthesecondinvestment.IthasahigherNPV.
d. Thesecondinvestmentisriskier.Thehigherrequiredreturnimpliesahigherriskfactor.
P1211. RiskadjustedratesofreturnusingCAPM
LG4;Challenge
a.
rX7%1.2(12%7%)7%6%13%
rY7%1.4(12%7%)7%7%14%
NPVcalculationforX:
N4,I13%,PMT$30,000
SolveforPV89,234.14
NPV$89,234.14$70,000
NPV$19,234.14
NPVcalculationforY:
CF0$78,000,CF1$22,000,CF2$32,000,CF3$38,000,CF4$46,000
SetI14%
b. TheRADRapproachprefersProjectYoverProjectX.TheRADRapproachcombinesthe
riskadjustmentandthetimeadjustmentinasinglevalue.TheRADRapproachismostoften
usedinbusiness.
P1212. RiskclassesandRADR
LG4;Basic
a.
ProjectX
CF0$180,000,CF1$80,000,CF2$70,000,CF3$60,000,
CF4$60,000,CF5$60,000
SetI22%
SolveforNPV$14.930.45
ProjectY
CF0$235,000,CF1$50,000,CF2$60,000,
CF3$70,000,CF4$80,000,CF5$90,000
SetI13%
ProjectZ
CF0$310,000,CF1$90,000,CF2$90,000,CF3$90,000,
CF4$90,000,CF5$90,000
[or,CF0$310,000,CF1$90,000,F15]
SetI15%
b. ProjectsXandYareacceptablewithpositiveNPVs,whileProjectZwithanegativeNPVis
not.ProjectX,withthehighestNPV,shouldbeundertaken.
P1213. UnequallivesANPVapproach
LG5;Intermediate
a.
MachineA
CF0$92,000,CF1$12,000,CF2$12,000,CF3$12,000,
CF4$12,000,CF5$12,000,CF6$12,000
[or,CF0$92,000,CF1$12,000,F16]
SetI12%
MachineB
CF0$65,000,CF1$10,000,CF2$20,000,CF3$30,000,CF4$40,000
SetI12%
MachineC
CF0$100,500,CF1$30,000,CF2$30,000,
CF3$30,000,CF4$30,000,CF5$30,000
[or,CF0$105,000,CF1$30,000,F15]
SetI12%
Rank
Machine
(NotethatMachineAisnotacceptableandcouldberejectedwithoutanyadditionalanalysis.)
b. MachineA
N6,I12%,PV$42,663.11
SolveforANPV(PMT)$10,376.77
MachineB
N4,I12%,PV$6,646.58
MachineC
N5,I12%,PV$7,643.29
Rank
Machine
c.
MachineBshouldbeacquiredsinceitoffersthehighestANPV.Notconsideringthe
differenceinprojectlivesresultedinadifferentrankingbasedinpartonMachineCs
NPVcalculations.
LG5;Intermediate
a.
ProjectX
CF0$78,000,CF1$17,000,CF2$25,000,CF3$33,000,CF4$41,000
SetI14%
ProjectY
CF0$52,000,CF1$28,000,CF2$38,000
SetI14%
ProjectZ
CF0$66,000,CF1$15,000,CF2$15,000,CF3$15,000,CF4$15,000,
CF5$15,000,CF6$15,000,CF7$15,000,CF8$15,000
[or,CF0$66,000,CF1$15,000,F18]
SetI14%
Rank
Project
b. ProjectX
N4,I14%,PV$
ProjectY
N2,I14%,PV$1801.17
ProjectZ
N5,I14%,PV$3582.96
Rank
Project
X
c.
ProjectYshouldbeacquiredsinceitoffersthehighestANPV.Notconsideringthedifference
inprojectlivesresultedinadifferentrankingbasedprimarilyontheunequallivesofthe
projects.
LG5;Intermediate
a.
Sell
CF0$200,000,CF1$200,000,CF2$250,000
SetI12%
License
CF0$200,000,CF1$250,000,CF2$100,000
CF3$80,000,CF4$60,000,CF5$40,000
SetI12%
Manufacture
CF0$450,000,CF1$200,000,CF2$250,000,CF3$200,000,
CF4$200,000,CF5$200,000,CF6$200,000
[or,CF0$450,000,CF1$200,000,F11,
CF2$250,000,F21,CF3$200,000,F34]
SetI12%
Rank
Alternativ
e
Manufactur
e
License
Sell
b. Sell
N2,I12%,PV$
License
N5,I12%,PV$220,704.25
Manufacture
N6,I12%,PV$412,141.16
c.
Rank
Alternati
ve
Sell
Manufact
ure
License
ComparingtheNPVsofprojectswithunequallivesgivesanadvantagetothoseprojectsthat
generatecashflowsoverthelongerperiod.ANPVadjustsforthedifferencesinthelengthof
theprojectsandallowsselectionoftheoptimalproject.Thistechniqueimplicitlyassumes
thatallprojectscanbeselectedagainattheirconclusionaninfinitenumberoftimes.
P1216. NPVandANPVdecisions
LG5;Challenge
a. b.
Unequal-Life Decisions
Annualized Net Present Value (ANPV)
Cost
Annual Benefits
Life
Sony
$(2,350)
$(2,700)
$900
3 years
Terminal value
Required rate of return
a.
Samsung
$400
9.0%
$1,000
4 years
$350
9.0%
CF0$2,350,CF1$900,CF2$900,CF3$900+$400$1,300
SetI9%
SolveforNPV$237.04
b. N3,I9%,PV$237.04
SolveforANPV(PMT)$93.64
c.
CF0$2,700,CF1$1,000,CF2$1,000,CF3$1,000,CF4$1,000+$350$1,350
SetI9%
SolveforNPV$787.67
d. N4,I9%,PV$787.67
SolveforANPV(PMT)$243.13
e.
RichardandLindashouldselecttheSonysetbecauseitsANPVof$243.13isgreaterthanthe
$93.64ANPVofSamsung.
P1217. RealoptionsandthestrategicNPV
LG6;Intermediate
a.
Valueofrealoptionsvalueofabandonmentvalueofexpansionvalueofdelay
Valueofrealoptions(0.25$1,200)(0.30$3,000)(0.10$10,000)
Valueofrealoptions$300$900$1,000$2,200
NPVstrategicNPVtraditionalValueofrealoptions1,7002,200$500
b. DuetotheaddedvaluefromtheoptionsReneshouldrecommendacceptanceofthecapital
expendituresfortheequipment.
c. Ingeneralthisproblemillustratesthatbyrecognizingthevalueofrealoptionsaprojectthat
wouldotherwisebeunacceptable(NPVtraditional0)couldbeacceptable(NPVstrategic0).Itis
thusimportantthatmanagementidentifyandincorporaterealoptionsintotheNPVprocess.
P1218. CapitalrationingIRRandNPVapproaches
LG6;Intermediate
a.
RankbyIRR
Project
IRR
InitialInvestment
TotalInvestment
$2,500,000
$2,500,000
23%
22
800,000
3,300,000
20
1,200,000
4,500,000
19
18
17
16
ProjectsF,E,andGrequireatotalinvestmentof$4,500,000andprovideatotalpresentvalue
of$5,200,000,andthereforeanNPVof$700,000.
b. RankbyNPV(NPVPVInitialinvestment)
Project
F
A
NPV
$500,000
400,000
Initial Investment
$2,500,000
5,000,000
C
B
D
G
E
300,000
300,000
100,000
100,000
100,000
2,000,000
800,000
1,500,000
1,200,000
800,000
ProjectAcanbeeliminatedbecausewhileithasanacceptableNPV,itsinitialinvestment
exceedsthecapitalbudget.ProjectsFandCrequireatotalinitialinvestmentof$4,500,000
andprovideatotalpresentvalueof$5,300,000andanetpresentvalueof$800,000.However,
thebestoptionistochooseProjectsB,F,andG,whichalsousetheentirecapitalbudgetand
provideanNPVof$900,000.
c.
Theinternalrateofreturnapproachusestheentire$4,500,000capitalbudgetbutprovides
$200,000lesspresentvalue($5,400,000$5,200,000)thantheNPVapproach.Sincethe
NPVapproachmaximizesshareholderwealth,itisthesuperiormethod.
d. ThefirmshouldimplementProjectsB,F,andG,asexplainedinpartc.
P1219. CapitalRationingNPVApproach
LG6;Intermediate
Project
PV
A
B
C
D
E
F
G
$384,000
210,000
125,000
990,000
570,000
150,000
960,000
Initial Investment
Total Investment
$100,000
$100,000
$100,000
$800,000
$200,000
$1,000,000
b. TheoptimalgroupofprojectsisProjectsC,F,andG,resultinginatotalnetpresentvalueof
$235,000.ProjectGwouldbeacceptedfirstbecauseithasthehighestNPV.Itsselection
leavesenoughofthecapitalbudgettoalsoacceptProjectCandProjectF.
P1220. Ethicsproblem
LG4;Challenge
Studentanswerswillvary.Somestudentsmightarguethatcompaniesshouldbeheldaccountable
foranyandallpollutionthattheycause.Otherstudentsmaytakethelargerviewthattheappropriate
goalshouldbethereductionofoverallpollutionlevels,andthatcarboncreditsareawayto
achievethatgoal.Fromaninvestorstandpoint,carboncreditsallowthepollutingfirmtomeet
legalobligationsinthemostcosteffectivemanner,thusimprovingthebottomlineforthe
companyandinvestor.
Case
Casestudiesareavailableonwww.myfinancelab.com.
Evaluating Cherone Equipments Risky Plans for Increasing Its Production

Capacity
a.
1. Plan X
CF0$2,700,000,CF1$470,000,CF2$610,000
CF3$950,000,CF4$970,000,CF5$1,500,000
SetI12%
PlanY
CF0$2,100,000,CF1$380,000,CF2$700,000
CF3$800,000,CF4$600,000,CF5$1,200,000
SetI12%
2. Usingafinancialcalculator,theIRRsare:
IRRX16.22%
IRRY18.82%
BothNPVandIRRfavorselectionofProjectY.TheNPVislargerby$79,254
($428,969$349,715)andtheIRRis2.6%higher.
b.
Plan X
CF0$2,700,000,CF1$470,000,CF2$610,000
CF3$950,000,CF4$970,000,CF5$1,500,000
SetI13%
PlanY
CF0$2,100,000,CF1$380,000,CF2$700,000
CF3$800,000,CF4$600,000,CF5$1,200,000
SetI15%
TheRADRNPVfavorsselectionofProjectX.
Ranking
Plan
NPV
IRR
RADRs
c.
Both NPV and IRR achieved the same relative rankings. However, making risk adjustments through the
RADRs caused the ranking to reverse from the nonrisk-adjusted results. The final choice would be to select
Plan X since it ranks first using the risk-adjusted method.
d.
Plan X
Valueofrealoptions0.25$100,000$25,000
NPVstrategic$261,105.40$25,000$286,105.40
PlanY
Valueofrealoptions0.20$500,000$100,000
NPVstrategic$225,412.37$100,000$325,412.37
e.
With the addition of the value added by the existence of real options, the ordering of the projects is reversed.
Project Y is now favored over Project X using the RADR NPV for the traditional NPV.
f.
Capital rationing could change the selection of the plan. Since Plan Y requires only $2,100,000 and Plan X
requires $2,700,000, if the firms capital budget was less than the amount needed to invest in Project X, the firm
would be forced to take Y to maximize shareholders wealth subject to the budget constraint.
Spreadsheet Exercise
TheanswertoChapter12sIsisCorporationspreadsheetproblemislocatedontheInstructorsResource
Centeronthetextbookscompanionwebsiteatwww.pearsonhighered.com/ircundertheInstructorsManual.
Group Exercise
Groupexercisesareavailableonwww.myfinancelab.com.
Riskwithinlongterminvestmentdecisionsisthetopicofthischapter.Theinvestmentprojectsofthe
previoustwochapterswillnowhaveriskvariablesintroduced.Thecashflowsestimatedpreviouslywill
nowbecharacterizedbyalackofcertainty.Eachestimateddollarflowisnowassignedthreepossible
levelsforthreepossiblestatesoftheworlds:pessimistic,mostlikelyandoptimistic.Originalestimates
serveasthemostlikelyvalueandtheothersareplacedaroundthisvalue.
Analysisoftheseestimatesbeginswithacalculationoftherangesforeachoutcome.AsimplifiedRADR
isthencalculatedusingthepreviouslydetermineddiscountrate.TheriskadjustedNPVisthencalculated.
Thefinaltaskistocompletethisthreechapterodyssey.
UsinginformationfromChapters10,11,and12,thegroupsareaskedtodefendtheirchoiceofinvestment
projects.Aspointedoutintheassignment,groupsshouldusethisassignmenttodefendtheirchoicesinthe
formofdocumentsaspresentedtotheirboardofdirectors.Thisconclusionshouldsummarizeallthework
doneacrossthechaptersandstudentsshouldtakeprideinthequantityoftheireffort.Itworkswelltohave
eachstudentgrouppresenttheirprojectanddecisiontotheremainderoftheclass,whocanbeviewedasa
boardofdirectors.
Integrative Case 5: Lasting Impressions Company

IntegrativeCase5involvesacompletelongterminvestmentdecision.TheLastingImpressionsCompany
isacommercialprinterfacedwithareplacementdecisioninwhichtwomutuallyexclusiveprojectshave
beenproposed.Thedataforeachpresshavebeendesignedtoresultinconflictingrankingswhenconsidering
theNPVandIRRdecisiontechniques.Thecaseteststhestudentsunderstandingofthetechniquesaswell
asthequalitativeaspectsofriskandreturndecisionmaking.
a.
1.
Calculation of initial investment for Lasting Impressions Company:
PressA
PressB
Installedcostofnewpress
Costofnewpress
Installationcosts
$830,000
$640,000
40,000
20,000
Totalcostnewpress
$870,000
$660,000
Aftertaxproceedssaleofoldasset
Proceedsfromsaleofoldpress
420,000
420,000
121,600
121,600
Taxonsaleofoldpress*
Totalproceedssaleofoldpress
(298,400)
Changeinnetworkingcapital**
Initialinvestment
*
Saleprice
$420,000
Bookvalue
116,000
Gain
$304,000
Taxrate(40%)
90,400
$662,000
$361,600
121,600
Bookvalue$400,000[(0.200.320.19)$400,000]$116,000
**
Cash
$25,400
Accountsreceivable
120,000
Inventory
(20,000)
Increaseincurrentassets
$125,400
Increaseincurrentliabilities
(35,000)
Increaseinnetworkingcapital
$90,400
2. Depreciation
Year
Cost
Rate
Depreciation
$870,000
0.20
$174,000
870,000
0.32
278,400
870,000
0.19
165,300
870,000
0.12
104,400
870,000
0.12
104,400
870,000
0.05
43,500
PressA
1
(298,400)
$870,000
PressB
1
$660,000
0.20
$132,000
660,000
0.32
211,200
660,000
0.19
125,400
660,000
0.12
79,200
660,000
0.12
79,200
660,000
0.05
33,000
$660,000
ExistingPress
1
$400,000
0.12(Yr.4)
$48,000
400,000
0.12(Yr.5)
48,000
400,000
0.05(Yr.6)
20,000
0
$116,000
Operatingcashinflows
Year
Earnings
before
Depreciation
andTaxes
Depre
ciation
Earnings Earnings
before
after
Taxes
Taxes
Old
Cash
Flow
Cash
Flow
Existing
Press
1
$120,000
$48,000
$72,000
$43,200
$91,200
120,000
48,000
72,000
43,200
91,200
120,000
20,000
100,000
60,000
80,000
120,000
120,000
72,000
72,000
120,000
120,000
72,000
72,000
Incre
mental
Cash
Flow
PressA
1
$250,000
$174,000
$76,000
$45,600
$219,600
$91,200 $128,400
270,000
278,400
8,400
5,040
273,360
91,200
182,160
300,000
165,300
134,700
80,820
246,120
80,000
166,120
330,000
104,400
225,600
135,360
239,760
72,000
167,760
370,000
104,400
265,600
159,360
263,760
72,000
191,760
43,500
43,500
26,100
17,400
17,400
Earnings
before
Depreciation
andTaxes
Depre
ciation
$210,000
$132,000
$78,000
$46,800
$178,800
$91,200 $87,600
210,000
211,200
1,200
720
210,480
91,200 119,280
210,000
125,400
84,600
50,760
176,160
80,000 96,160
210,000
79,200
130,800
78,480
157,680
72,000 85,680
210,000
79,200
130,800
78,480
157,680
72,000 85,680
33,000
33,000
19,800
13,200
0 13,200
Year
Earnings Earnings
before
after
Taxes
Taxes
Incre
mental
Cash
Flow
Old
Cash
Flow
Cash
Flow
PressB
3. Terminalcashflow
PressA
PressB
Aftertaxproceedssaleofnewpress
Proceedsonsaleofnewpress
$400,000
$330,000
Taxonsaleofnewpress*
(142,600)
(118,800)
Totalproceedsnewpress
$257,400
$211,200
Aftertaxproceedssaleofoldpress
Proceedsonsaleofoldpress
Taxonsaleofoldpress**
(150,000)
(150,000)
60,000
60,000
Totalproceedsoldpress
(90,000)
90,400
$257,800
$121,200
Changeinnetworkingcapital
Terminalcashflow
PressB
PressA
Saleprice
$400,000
Less:Bookvalue(Yr.6)
Gain
0.40
Tax
$142,600
Saleprice
Taxrate
Tax
Saleprice
Gain
Taxrate
Tax
$150,000
Gain
43,500
$356,500
Taxrate
**
(90,000)
0
$150,000
0.40
$60,000
$330,000
33,000
$297,000
0.40
$118,800
CashFlows
Year
PressA
PressB
($662,000)
$128,400
($361,600)
$87,600
182,160
119,280
166,120
96,160
167,760
85,680
5*
449,560
206,880
Initialinvestment
1
Year5
PressA
PressB
Operatingcashflow
$191,760
$85,680
Terminalcashinflow
257,800
121,200
Total
$449,560
$206,880
b.
PressA
c.
Relevant cash flow
CumulativeCashFlows
Year
PressA
PressB
$128,400
$87,600
310,560
206,880
476,680
303,040
644,440
388,720
1,094,000
595,600
1. PressA: 4years[(662,000644,440)191,760]
Payback 4(17,560191,760)
Payback 4.09years
PressB: 3years[(361,600303,040)85,680]
Payback 3(58,56085,680)
Payback 3.68years
2. PressA
CF0$662,000,CF1$128,400,CF2$182,160,CF3$166,120,
CF4$167,760,CF5$449,560
SetI14%
PressB
CF0$361,600,CF1$87,600,CF2$119,280,CF3$96,160,
CF4$85,680,CF5$206,880
SetI14%
3. IRR:
PressA: 15.8%
PressB: 17.1%
d.
DataforNPVProfile
NPV
DiscountRate
PressA
PressB
0%
$432,000
$234,000
14%
35,455
29,953
15.8%
17.1%
Whenthecostofcapitalisbelowapproximately15%.PressAispreferredoverPressB,
whileatcostsgreaterthan15%,PressBispreferred.Sincethefirmscostofcapitalis14%,
conflictingrankingsexist.PressAhasahighervalueandisthereforepreferredoverPressB
usingNPV,whereasPressBsIRRof17.1%causesittobepreferredoverPressA,whose
IRRis15.8%usingthismeasure.
e.
a.
If the firm has unlimited funds, Press A is preferred.
b. Ifthefirmissubjecttocapitalrationing,PressBmaybepreferred.
f.
The risk would need to be measured by a quantitative technique such as certainty equivalents or risk-adjusted
discount rates. The resultant NPV of Press A could then be compared to the risk-adjusted NPV of Press B and a
decision made.

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Chapter 12

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Chapter12

Suggested Answer to Opener in Review Question

Answers to Review Questions

Suggested Answer to Focus on Practice Box: The Monte Carlo

Suggested Answer to Focus on Ethics Box:

Answers to Warm-Up Exercises

Using IRR as selection criteria

Risk-adjusted discount rates

Evaluating Cherone Equipments Risky Plans for Increasing Its Production

Integrative Case 5: Lasting Impressions Company

Calculation of initial investment for Lasting Impressions Company:

Relevant cash flow

If the firm has unlimited funds, Press A is preferred.

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