Chapter 10 Homework key The problem number from the book are 4* edition mumbers. I've edited the questions as indicated on the assignment web page. Also note that there may still be present values in the Key shown 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 Co c G Gs (S700) $200 $500 S244 a. What is the project’s payback period? . Calculate the projects NPV at 12% ¢. Calculate the project’s IRR 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&e. Year cH 0 (S700) 1 $200 2 $500 3 $244 I b. Compute NPV = $50.84 c. Compute IRR = 16.03% 3. Clancy Ine. is considering a project with the following cash flows. es ($7,800) $2,300 33,500 $4,153 Claney 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 Docs this project warrant further consideration? b. Should Clancy accept the project based on its NPV if the company’s cost of capital is 8%? ¢. Based on IRR, what conclusion will the firm reach? SOLUTIO} a. The cumulative cash flow is Year 0 1 Cash Flow ($7,800) $2,300 $3,500 SAL Cumulative ($7,800) (S5.500) (52.000) 82, Cumulative cash flow is negative after two years and positive after three, hence the payback period is between two and three years (2 + 2000/4183 = 2.48). Hence Clancy's policy would require finther evaluation using time value based methodsb. and c. The project’s NPV at §% is calculated as follows: Year ce 0 (87.800) 1 3 1 8% compute NPV= $ 627.10 compute IRR = 12.0% The project has a positive NPV which implies that it should be accepted. The IRR 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: —oo_ —a GG: ($25,000) $10,000 512,000 35,000 $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 om a stand-alone basis? ¢. Calculate the project's IRR using your calculator. Does IRR indicate acceptance on a stand- alone basis? SOLUTION: a ci c fe ce Cash flows: $10,000 $12,000 $5,000 $8,000 ‘Cumulative cash flows: ($25,000) ($15,000) ($3,000), $2,000 $10,000 Payback petiod = 2 + 2000/5000 = 2.6 yrs. Yes, since payback < 3yrs be! CF. = (25,000) b. compute NPV =3802.79: Yes. NPV does indicate acceptance on a stand-alone basis. compute IRR = 16.35% which implies acceptance of the project since 16.35% > 9%. 6. Project Alpha requites an initial outlay of $35,000 and results in a single cash inflow of $56,367.50 after five years ‘TP the cost of capital is 8% what are Alpha's NPV? Is the project acceptable under NPV? bb, What is project Alphas IRR? Is it acceptable under IRR?cc. What is Alpha’s NPV if the cost of capital is 12%? Is the project acceptable under that condition 4. What is Alpha's payback period? Does payback make much sense for a project like Alpha? Why? SOLUTION: a. Find the PV of the FV: n=S, I=8, PMT=0, FV=56367.50, solve for PV=38362.77 NPV =~$35,000 + $38,363.77 = $3,362.77 Acceptable since NPV > 0. b. Using: N $, PV=-35000, FV=56375.5; PMT=0: solve I= 10. so IRR = 10% Acceptable since IRR > 8%. c. At 12% cost of capital: n=5, I=12, PMT=0, FV=86367.50, solve for PV=31984.43 NPV =-$35,000 ~ $31,984.43 $3.01. Unacceptable since NPV < 0. Also could have used the CF, calculator function. 4d. 4.62 years. Yes. it payback makes sense because it tales about five years to recover the absolute value of the investment regardless of the fact that the entire retum 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 projects 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 simple division calculation is possible because the retums are constant in amount and. regular in time (an annuity), b.N: . PY 75000; FV=0; PMT= 20806: solve I= 12%: IRR= The project is acceptable since IRR > 10%. compute NPV =3871.11 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 122. The project cash flows are summarized as follows: ProjectA Project B Co ($25,000) ($23,000) a $14,742 $ 6641 G $14,742 $ 6641 G $14,742 S 6641 Cs 3 6641 Gs S 6641 Cs 3 6641 G $ 6641 Cs 5 6.641 Co $ 6641 a. Compare the projects by using Payback, 'b, Compare the projects by using NPV. €. Compare the projects by using IRR, €. Compare the projects by using the EAA method, £ Chose a project and justify your choice. SOLUTION: a Payback Period A: PIB = $25,000 / $14,742 = 1.7 years B: PIB = $23,000 / $6.641 = 3.5 years Project A is preferred. bse. Fo (525.000) ch 2 ch 2 CF: $14,742 1 12% compute NPV = 10407.80 compute IRR = 35% Fo (823,000) CF S 6.641 cE $ 6641 cH S 6.641 CEs S 6.641 CFs S 6,641 Eo S 6.641 CF, 5 6.641 CEs S 6.641 CFs S 6.641 1 1 compute NPV = 12384.91 compute IRR = 25% Project B is preferred, by NPV Project A is preferred by IRReo 2; PV=-10407; solve PMT = $4.333 = EAA. B: N= 12; PV= -12385: solve PMT = $2324 = EAA Project A is preferred. because it has the larger EAA. Cost of Capital 8% 13% 9% 10% $35,000 $15,000 $20,000 $25,000 £ 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. Project, Initial Length Annual Investment —(inyears) Cash Flow A $100,000 5 $35,000 B $200,000 4 c 300.0007 $50,000 D $400,000 $56,098 E 6 $75,000 SOLUTION: A. PMT=35,000 Nes Vy FV PV B.— PV=(235,000) N WY=13 FV=0 PMT 79,005.64 C PV=G15,000) PMT = 50,000 N=7 PMT = 56,098 FV=0 which means the Initial investment was $25,000 less or $301.644.55 139,744.85 which make the NPV = $39,744.8518 Calculate IRRs for the projects in the previous problem, SOLUTION (also could use the CF) function): A B c D E PV (100,000) (200,000) (300,000) (400,000) (301,644.55) PMT 35,000 79,005.64 50,000 56.098 75,000 N 3 4 1 13 6 FV 0 0 0 0 0 vw 22.11% 21.19% 4.01% 9.93% 12.78% 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. Tt will produce the same savings in clectricity 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 5-year refurb. ref, CF (250,000) (300,000) Ch 50,000 50,000 ca 30.000 50.000 ro 50,000 50,000 Ch 30.000 50,000 CE 50,000 10.000 CEs 30.000 50,000 CF; 50,000 50.000 CFs 30.000 50.000 CP 30,000 50.000 Fw 30,000 10,000 1=85% NPV 15.129 (16.226) NPY tells us to select the $250,000 storage unit