Chapter 10

Capital Budgeting Techniques

◼ Answers to Warm-Up Exercises

E10-1. Payback period
Answer: The payback period for Project Hydrogen is 4.29 years. The payback period for Project Helium is 5.75
years. Both projects are acceptable because their payback periods are less than Elysian Fields’
maximum payback period criterion of 6 years.

E10-2. NPV
Answer:

Year Cash Inflow Present Value

1 $850,000 $ 772,727.27
2 768,000 634,710.74
3 643,000 483,095.42
4 565,000 385,902.60
5 400,000 248,368.53
Total $2,524,804.56
NPV = $2,524,804.56 − $2,520,000 = $4,804.56
Sweet Potato should acquire the new cooking machine.

E10-3: NPV comparison of two projects

Answer: Project Kelvin
Present value of expenses –$45,000
Present value of cash inflows 51,542 (PMT = $20,000, N = 3, I = 8, Solve for PV)
NPV $ 6,542
Project Thompson
Present value of expenses −$275,000
Present value of cash inflows 277,373 (PMT = $60,000, N = 6, I = 8, Solve for PV)
NPV $ 2,373
Based on NPV analysis, Axis Corporation should choose an overhaul of the existing system.

© Pearson Education Limited, 2015.

E10-4: IRR
Answer: You may use a financial calculator to determine the IRR of each project. Choose the project with the
higher IRR.
Project T-Shirt
PV = −15,000, N = 4, PMT = 8,000
Solve for I
IRR = 39.08%
Project Board Shorts
PV = −25,000, N = 5, PMT = 12,000
Solve for I
IRR = 38.62%
Based on IRR analysis, Billabong Tech should choose project T-Shirt.

E10-5: NPV
Answer: Note: The IRR for Project Terra is 10.68% while that of Project Firma is 10.21%. Furthermore, when
the discount rate is zero, the sum of Project Terra’s cash flows exceed that of Project Firma. Hence, at
any discount rate that produces a positive NPV, Project Terra provides the higher net present value.

◼ Solutions to Problems
Note to instructor: In most problems involving the IRR calculation, a financial calculator has been used. Answers
to NPV-based questions in the first 10 problems provide detailed analysis of the present value of individual cash
flows. Thereafter, financial calculator worksheet keystrokes are provided. Most students will probably employ
calculator functionality to facilitate their problem solution in this chapter and throughout the course.
P10-1. Payback period
LG 2; Basic
a. $84,000  $7,000 =12 years
b. The company should not accept the project, since payback period of 12 years exceeds the entity’s
maximum acceptable one.

P10-2. Payback comparisons

LG 2; Intermediate
a. Machine 1: $25,000  $6,500 =3.85 years
Machine 2: $75,000  $9,500 =7.89 years
b. Only Machine 1 has a payback faster than 5 years and is acceptable.
c. The firm will accept the first machine because the payback period of 3.85 years is
less than the 5-year maximum payback required by Colorado Cleaning.
d. Machine 2 has returns that last 20 years while Machine 1 has only 8 years of returns. Payback cannot
consider this difference; it ignores all cash inflows beyond the payback period.

P10-3. Choosing between two projects with acceptable payback periods

LG 2; Intermediate
a.

Project A Project B
Cash Investment Cash Investment
Year Inflows Balance Year Inflows Balance
0 −$100,000 0 −$100,000
1 $10,000 −90,000 1 40,000 −60,000
2 20,000 −70,000 2 30,000 −30,000
3 30,000 −40,000 3 20,000 −10,000
4 40,000 0 4 10,000 0
5 20,000 5 20,000

Both Project A and Project B have payback periods of exactly 4 years.

b. Based on the minimum payback acceptance criteria of 4 years set by John Shell, both projects should
be accepted. However, because they are mutually exclusive projects, John should accept Project B.
c. Project B is preferred over A because the larger cash flows are in the early years of the project. The
quicker cash inflows occur, the greater their value.
P10-4. Personal finance: Long-term investment decisions, payback period
LG 4

a. and b.

Project A Project B
Annual Cumulative Annual Cumulative
Year Cash Flow Cash Flow Cash Flow Cash Flow
0 $(9,000) $(9,000) $(9,000) $(9,000)
1 2,200 (6,800) 1,500 (7,500)
2 2,500 (4,300) 1,500 (6,000)
3 2,500 (1,800) 1,500 (4,500)
4 2,000 3,500 (1,000)
5 1,800 4,000
Total Cash Flow 11,000 12,000
Payback Period 3 + 1,800/2,000 = 3.9 years 4 + 1,000/4,000 = 4.25 years

c. The payback method would select Project A because its payback of 3.9 years is lower than Project B’s
payback of 4.25 years.

d. One weakness of the payback method is that it disregards expected future cash flows as in the case of
Project B.

P10-5. NPV
LG 3; Basic
NPV = PVn − Initial investment
a. N = 15, I = 9%, PMT = $150,000
Solve for PV = $1,209,103.26
NPV = $1,209,103.26 − $1,000,000
NPV = $209,103
NPV = $209,103.26, which means that the project is acceptable.
b. N = 15, I = 9%, PMT = $320,000
Solve for PV = 2,579,420.30
NPV = $2,579,420.30 − $2,500,000
NPV = $
NPV = $79,420.30, which means that the project is acceptable.
c. N = 15, I = 9%, PMT = $365,000
Solve for PV = $2,942,151.28
NPV = $2,942,151.28 − $3,000,000
NPV = −$57,848.72
NPV = −$57,848.72, which means that the project is unacceptable.

P10-6. NPV for varying cost of capital

LG 3; Basic
 a. 8%
N =5, I =8%, PMT = $65,000
Solve for PV = $259,526.15
NPV =PVn− Initial investment
NPV = $259,526.15− $235,000
NPV = $24,526.15
Accept; positive NPV

b. 10%
N =5, I = 10%, PMT = $65,000
Solve for PV = $246,401.14
NPV =PVn− Initial investment
NPV = $246,401.14− $235,000
NPV = $11,401.14
Accept; positive NPV
c. 15%
N =5, I = 15%, PMT = $65,000
Solve for PV = $217,890.08
NPV =PVn− Initial investment
NPV = $217,890.08− $235,000
NPV = -$17,109.92
Reject; negative NPV
P10-7. NPV—independent projects
LG 3; Intermediate
Project A
N = 10, I = 14%, PMT = $4,000
Solve for PV = $20,864.46
NPV = $20,864.46 − $26,000
NPV = −$5,135.54
Reject
Project B—PV of Cash Inflows
CF0 = −$500,000; CF1 = $100,000; CF2 = $120,000; CF3 = $140,000; CF4 = $160,000;
CF5 = $180,000; CF6 = $200,000
Set I = 14%
Solve for NPV = $53,887.93
Accept
Project C—PV of Cash Inflows
CF0 = −$170,000; CF1 = $20,000; CF2 = $19,000; CF3 = $18,000; CF4 = $17,000;
CF5 = $16,000; CF6 = $15,000; CF7 = $14,000; CF8 = $13,000; CF9 = $12,000;
CF10 = $11,000,
Set I = 14%
Solve for NPV = −$83,668.24
Reject
Project D
 N = 8, I = 14%, PMT = $230,000
Solve for PV = $1,066,938.70
NPV = PVn − Initial investment
NPV = $1,066,939 − $950,000
NPV = $116,938.70
Accept
Project E—PV of Cash Inflows
CF0 = −$80,000; CF1 = $0; CF2 = $0; CF3 = $0; CF4 = $20,000; CF5 = $30,000; CF6 = $0;
CF7 = $50,000; CF8 = $60,000; CF9 = $70,000
Set I = 14%
Solve for NPV = $9,963.63
Accept

P10-8. NPV
LG 3; Challenge
a. N = 5, I = 9%, PMT = $385,000
Solve for PV = $1,497,515.74
The immediate payment of $1,500,000 is not preferred because it has a higher present value than does
the annuity.
b. N = 5, I = 9%, PV = −$1,500,000
Solve for PMT = $385,638.69
c. Present valueAnnuity Due = PVordinary annuity  (1 + discount rate)
$1,497,515.74 (1.09) = $1,632,292
Calculator solution: $1,632,292
Changing the annuity to a beginning-of-the-period annuity due would cause Simes Innovations to prefer
to make a $1,500,000 one-time payment because the present value of the annuity due is greater than
the $1,500,000 lump-sum option.
d. No, the cash flows from the project will not influence the decision on how to fund the project. The
investment and financing decisions are separate.

P10-9. NPV and maximum return

LG 3; Challenge
a. N =5, I = 15%, PMT = $68,500
Solve for PV = $229,622.62
NPV = PV − Initial investment
 NPV = $229,622.62− $245,000
NPV = –$15,377.38
Reject this project due to its negative NPV.
b. N =5, PV= -$245,000, PMT = $68,500
Solve for IRR=12.317%
12% is the maximum required return that the firm could have for the project to be acceptable. Since the
firm’s required return is 15% the cost of capital is greater than the expected return and the project is
rejected.

P10-10. NPV—mutually exclusive projects

LG 3; Intermediate
a. and b.
Press A
CF0 = −$85,000; CF1 = $18,000; F1 = 8
Set I = 15%
Solve for NPV = −$4,228.21
Reject
Press B
CF0 = −$60,000; CF1 = $12,000; CF2 = $14,000; CF3 = $16,000; CF4 = $18,000;
CF5 = $20,000; CF6 = $25,000
Set I = 15%
Solve for NPV = $2,584.34
Accept
Press C
CF0 = −$130,000; CF1 = $50,000; CF2 = $30,000; CF3 = $20,000; CF4 = $20,000;
CF5 = $20,000; CF6 = $30,000; CF7 = $40,000; CF8 = $50,000
Set I = 15%
Solve for NPV = −$15,043.89
Accept
c. Ranking—using NPV as criterion
Rank Press NPV
1 C $15,043.89
2 B 2,584.34
3 A −4,228.21

d. Profitability Indexes
Profitability Index =  Present Value Cash Inflows  Investment
Press A: $80,771.79  $85,000 = 0.95
Press B: $62,584.34  $60,000 = 1.04
Press C: $145,043.89  $130,000 = 1.12
e. The profitability index measure indicates that Press C is the best, then Press B, then Press A (which is
unacceptable). This is the same ranking as was generated by the NPV rule.
P10-11. Personal finance: Long-term investment decisions, NPV method
LG 3
Key information:
Cost of EMBA program $153,000
Annual incremental benefit $ 48,000
Time frame (years) 40
Opportunity cost 5.0%
Calculator Worksheet Keystrokes:
CF0 = −153,000
CF1 = 48,000
F1 = 40
Set I = 5%
Solve for NPV = −153,000 + [48,000 / (1.05) ^40]
= −153,000 + 6818.19 = −146,181
The financial benefits do not outweigh the cost of the EMBA program as the NPV is negative.

P10-12. Payback and NPV

LG 2, 3; Intermediate

a.
Project Payback Period
A $40,000  $13,000 = 3.08 years
B 3 + ($10,000  $16,000) = 3.63 years
C 2 + ($5,000  $13,000) = 2.38 years

Project C, with the shortest payback period, is preferred.

b. Worksheet keystrokes

Year Project A Project B Project C

0 −$40,000 −$40,000 −$40,000
1 13,000 7,000 19,000
2 13,000 10,000 16,000
3 13,000 13,000 13,000
4 13,000 16,000 10,000
5 13,000 19,000 7,000

Solve for $2,565.82 −$322.53 $5,454.17

NPV
Accept Reject Accept

Project C is preferred using the NPV as a decision criterion.

c. At a cost of 16%, Project C has the highest NPV. Because of Project C’s cash flow characteristics,
high early-year cash inflows, it has the lowest payback period and the
highest NPV.
P10-13. NPV and EVA
LG 3; Intermediate
a. NPV = −$860,000 + $320,000  0.12 = $1,806,667

b. Annual EVA = $320,000 – ($860,000 x 0.12) = $216,800

c. Overall EVA = $216,800  0.12 = $1,806,667

In this case, NPV and EVA give exactly the same answer.

P10-14. IRR—Mutually exclusive projects

LG 4; Intermediate
IRR is found by solving:
n
 CFt 
$0 =   t 
− initial investment
t =1  (1 + IRR) 

Most financial calculators have an “IRR” key, allowing easy computation of the internal rate of return.
The numerical inputs are described below for each project.
Project A
CF0 = −$90,000; CF1 = $20,000; CF2 = $25,000; CF3 = $30,000; CF4 = $35,000; CF5 = $40,000
Solve for IRR = 17.43%
If the firm’s cost of capital is below 17%, the project would be acceptable.
Project B
CF0 = −$490,000; CF1 = $150,000; CF2 = $150,000; CF3 = $150,000; CF4 = $150,000
[or, CF0 = −$490,000; CF1 = $150,000, F1= 4]
Solve for IRR = 8.62%
The firm’s maximum cost of capital for project acceptability would be 8.62%.
Project C
CF0 = −$20,000; CF1 = $7500; CF2 = $7500; CF3 = $7500; CF4 = $7500; CF5 = $7500
[or, CF0 = −$20,000; CF1 = $7500; F1 = 5]
Solve for IRR = 25.41%
The firm’s maximum cost of capital for project acceptability would be 25.41%.
Project D
CF0 = −$240,000; CF1 = $120,000; CF2 = $100,000; CF3 = $80,000; CF4 = $60,000
Solve for IRR = 21.16%
The firm’s maximum cost of capital for project acceptability would be 21% (21.16%).

P10-15. IRR
LG 4; Intermediate
 The IRR of the project is 4%. Because the IRR is lower than the firm’s cost of capital, the firm should
reject the project. However, note that in this case, the project’s cash flows have the opposite sign from
what we typically see. That is, in this project, there is an upfront inflow (not an outflow) followed by
outflows (not inflows) in the latter years. In a sense, the firm is borrowing money from its customers,
receiving $200 up front and paying back $106 in each of the next two years. In a project like this, the IRR
decision rule is the opposite of the normal case. Because inflows come first followed by outflows, the
firm should accept this project precisely because its IRR is low relative to the cost of capital (borrowing
at a low rate is a good thing). To see this more clearly, calculate the project NPV, and you will see that it
is positive:

NPV = 200 − (106 / 1.07 ) − (106 / 1.07 2 ) = 8.35  0

The NPV is positive, so the project is acceptable.

P10-16. IRR—Mutually exclusive projects

LG 4; Intermediate
IRR is the rate of return at which NPV equals zero

IRR is found by solving:

n
 CFt 
$0 =   t 
− initial investment
t =1  (1 + IRR) 

The numerical inputs are described below for project X and Y.

a. and b.
Project X
CF0 = –$980,000; CF1 = $150,000; CF2 = $170,000; CF3 = 220,000; CF4 = $270,000
CF5 = $340,000
Solve for IRR = 4.8588; since IRR > cost of capital (4%), accept.
Project Y
CF0 = −$363,000; CF1 = $110,000; CF2 = $98,000; CF3 = $93,000; CF4 = $82,000
CF5 = $67,000
Solve for IRR = 8.2906%; since IRR  cost of capital (4%), accept.
c. Project Y, with the higher IRR, is preferred, although both are acceptable.

P10-17. Personal Finance: Long-term investment decisions, IRR method

LG 4; Intermediate

IRR is the rate of return at which NPV equals zero

Computer inputs and output:

N = 5, PV = $33,000, PMT = $8,300
Solve for IRR =8.16%

Required rate of return: 7%

Decision: Accept the investment opportunity

P10-18. IRR, investment life, and cash inflows

LG 4; Challenge
a. N = 10, PV = −$61,450, PMT = $10,000
Solve for I = 10.0%
The IRR  cost of capital; reject the project.
 b. I = 15%, PV = −$61,450, PMT = $10,000
Solve for N = 18.23 years
The project would have to run a little more than 8 more years to make the project acceptable with the
15% cost of capital.
c. N = 10, I = 15%, PV = $61,450
Solve for PMT = $12,244.04

P10-19. NPV and IRR

LG 3, 4; Intermediate
a. N = 5, I = 8%, PMT = 65,000
Solve for PV = $259,526.15
NPV = PV − Initial investment
NPV = $259,526.15 − $248,250
NPV = $11,276.15
b. N =5, PV = $248,250, PMT = $65,000
Solve for I = 9.71%
c. The project should be accepted since the NPV  0 and the IRR  the cost of capital.

P10-20. NPV, with rankings

LG 3, 4; Intermediate
a. NPVA = $45,665.50 (N = 3, I = 15, PMT = $20,000) − $50,000
NPVA = −$4,335.50
Or, using NPV keystrokes
CF0 = −$50,000; CF1 = $20,000; CF2 = $20,000; CF3 = $20,000
Set I = 15%
NPVA = −$4,335.50
Reject
NPVB Key strokes
CF0 = −$100,000; CF1 = $35,000; CF2 = $50,000; CF3 = $50,000
Set I = 15%
Solve for NPV = $1,117.78
Accept
NPVC Key strokes
CF0 = −$80,000; CF1 = $20,000; CF2 = $40,000; CF3 = $60,000
Set I = 15%
Solve for NPV = $7,088.02
Accept
NPVD Key strokes
CF0 = −$180,000; CF1 = $100,000; CF2 = $80,000; CF3 = $60,000
Set I = 15%
Solve for NPV = $6,898.99
Accept
 b.

Rank Press NPV

1 C $7,088.02
2 D 6,898.99
3 B 1,117.78
4 A −4335.50

c. Using the calculator, the IRRs of the projects are:

Project IRR
A 9.70%
B 15.63%
C 19.44%
D 17.51%

Because the lowest IRR is 9.7%, all of the projects would be acceptable if the cost of capital was
9.7%.
Note: Because Project A was the only rejected project from the four projects, all that was needed to
find the minimum acceptable cost of capital was to find the IRR of A.

P10-21. All techniques, conflicting rankings

LG 2, 3, 4: Intermediate
a.

Project A Project B
Cash Investment Cash Investment
Year Inflows Balance Year Inflows Balance
0 −$150,000 0 −$150,000
1 $45,000 −105,000 1 $75,000 −75,000
2 45,000 −60,000 2 60,000 −15,000
3 45,000 −15,000 3 30,000 +15,000
4 45,000 +30,000 4 30,000 0
5 45,000 30,000
6 45,000 30,000

$150,000
Payback A = = 3.33 years = 3 years, 4 months
$45,000
$15,000
Payback B = 2 years + years = 2.5 years = 2 years, 6 months
$30,000

b. At a discount rate of zero, dollars have the same value through time and all that is needed is a
summation of the cash flows across time.
NPVA = ($45,000  6) − $150,000 = $270,000 − $150,000 = $120,000
NPVB = $75,000 + $60,000 + $120,000 − $150,000 = $105,000
c. NPVA:
CF0 = −$150,000; CF1 = $45,000; F1 = 6
Set I = 9%
Solve for NPVA = $51,866.34
 NPVB:
CF0 = −$150,000; CF1 = $75,000; CF2 = $60,000; CF3 = $120,000
Set I = 9%
Solve for NPV = $51,112.36
d. IRRA:
CF0 = −$150,000; CF1 = $45,000; F1 = 6
Solve for IRR = 19.91%
IRRB:
CF0 = −$150,000; CF1 = $75,000; CF2 = $60,000; CF3 = $120,000
Solve for IRR = 22.71%
e.
Rank
Project Payback NPV IRR
A 2 1 2
B 1 2 1

The project that should be selected is A. The conflict between NPV and IRR is due partially to the
reinvestment rate assumption. The assumed reinvestment rate of Project B is 22.71%, the project’s
IRR. The reinvestment rate assumption of A is 9%, the firm’s cost of capital. On a practical level,
Project B may be selected due to management’s preference for making decisions based on percentage
returns and their desire to receive a return of cash quickly.
f. NPVA:
CF0 = −$150,000; CF1 = $45,000; F1 = 6
Set I = 12%
Solve for NPVA = $35,013
NPVB:
CF0 = −$150,000; CF1 = $75,000; CF2 = $60,000; CF3 = $30,000; F01 = 
Set I = 12%
Solve for NPV = $37,436
At a cost of capital of 12%, the NPV of Project A is $35,013, and the NPV of Project B is $37,436. In
this case, Project B appears to be the better project, in contrast to the previous NVP-based rankings,
which showed Project A to be superior. Notice that Project B pays most of its cash in the early years.
This makes its NPV less sensitive to the cost of capital. The NPVs of both projects fall as the cost of
capital rises, but the NPV of Project A falls more rapidly.

P10-22. Payback, NPV, and IRR

LG 2, 3, 4; Intermediate
a. Payback period
Balance after 3 years: $95,000 − $20,000 − $25,000 − $30,000 = $20,000
3 + ($20,000  $35,000) = 3.57 years
b. NPV computation
CF0 = −$95,000; CF1 = $20,000; CF2 = $25,000; CF3 = $30,000; CF4 = $35,000
CF5 = $40,000
Set I = 12%
Solve for NPV = $9,080.60
 $20,000 $25,000 $30,000 $35,000 $40,000
c. $0 = + + + + − $95,000
(1 + IRR) (1 + IRR)
1 2
(1 + IRR) (1 + IRR)
3 4
(1 + IRR)5
CF0 = −$95,000; CF1 = $20,000; CF2 = $25,000; CF3 = $30,000; CF4 = $35,000
CF5 = $40,000
Solve for IRR = 15.36%
d. NPV = $9,080; because NPV  0, accept
IRR = 15%; because IRR  12% cost of capital, accept
The project should be implemented because it meets the decision criteria for both NPV and IRR.

P10-23. NPV, IRR, and NPV profiles

LG 3, 4, 5; Challenge
a. and b.
Project A
CF0 = −$130,000; CF1 = $25,000; CF2 = $35,000; CF3 = $45,000
CF4 = $50,000; CF5 = $55,000
Set I = 12%
NPVA = $15,237.71
Based on the NPV, the project is acceptable because the NPV is greater than zero.
Solve for IRRA = 16.06%
Based on the IRR, the project is acceptable because the IRR of 16% is greater than the 12% cost of
capital.
Project B
CF0 = −$85,000; CF1 = $40,000; CF2 = $35,000; CF3 = $30,000
CF4 = $10,000; CF5 = $5,000
Set I = 12%
NPVB = $9,161.79
Based on the NPV, the project is acceptable because the NPV is greater than zero.
Solve for IRRB = 17.75%
Based on the IRR, the project is acceptable because the IRR of 17.75% is greater than the 12% cost of
capital.
c.
 Data for NPV Profiles
NPV
Discount Rate A B
0% $80,000 $35,000
12% $15,238 $9,161
15% — $ 4,177
16% 0 —
18% — 0

d. The net present value profile indicates that there are conflicting rankings at a discount rate less than
the intersection point of the two profiles (approximately 15%). The conflict in rankings is caused by
the relative cash flow pattern of the two projects. At discount rates greater than approximately 15%,
Project B is preferable; less than approximately 15%, Project A is better. Based on Thomas
Company’s 12% cost of capital, Project A should be chosen.
e. Project A has an increasing cash flow from Year 1 through Year 5, whereas Project B has a
decreasing cash flow from Year 1 through Year 5. Cash flows moving in opposite directions often
cause conflicting rankings. The IRR method reinvests Project B’s larger early cash flows at the higher
IRR rate, not the 12% cost of capital.

P10-24. All techniques—decision among mutually exclusive investments

LG 2, 3, 4, 5, 6; Challenge

Project
A B C
Cash inflows (years 1−5) $20,000 $ 31,500 $ 32,500
a. Payback* 3 years 3.2 years 3.4 years
b. NPV* $10,345 $ 10,793 $ 4,310
c. IRR* 19.86% 17.33% 14.59%
*
Supporting calculations shown below:
a. Payback Period: Project A: $60,000  $20,000 = 3 years
Project B: $100,000  $31,500 = 3.2 years
Project C: $110,000  $32,500 = 3.4 years
b. NPV
Project A
CF0 = −$60,000; CF1 = $20,000; F1 = 5
Set I = 13%
Solve for NPVA = $10,344.63
Project B
CF0 = −$100,000; CF1 = $31,500; F1 = 5
Set I = 13%
Solve for NPVB = $10,792.78
 Project C
CF0 = −$110,000; CF1 = $32,500; F1 = 5
Set I = 13%
Solve for NPVC = $4,310.02
c. IRR
Project A
CF0 = −$60,000; CF1 = $20,000; F1 = 5
Solve for IRRA = 19.86%
Project B
CF0 = −$100,000; CF1 = $31,500; F1 = 5
Solve for IRRB = 17.34%
Project C
CF0 = −$110,000; CF1 = $32,500; F1 = 5
Solve for IRRC = 14.59%
d.

Data for NPV Profiles

NPV
Discount Rate A B C
0% $40,000 $57,500 $52,500
13% $10,345 10,793 4,310
15% 7,043 5,593 0
17% 3,987 0 —
20% 0 — —

The difference in the magnitude of the cash flow for each project causes the NPV to compare
favorably or unfavorably, depending on the discount rate.
e. Even though A ranks higher in Payback and IRR, financial theorists would argue that B is superior
because it has the highest NPV. Adopting B adds $448.15 more to the value of the firm than does
adopting A.
P10-25. All techniques with NPV profile—mutually exclusive projects
LG 2, 3, 4, 5, 6; Challenge
a. Project A
Payback period
Year 1 + Year 2 + Year 3 = $60,000
Year 4 = $20,000
Initial investment = $80,000
Payback = 3 years + ($20,000  30,000)
Payback = 3.67 years
Project B
Payback period
$50,000  $15,000 = 3.33 years
b. Project A
CF0 = −$80,000; CF1 = $15,000; CF2 = $20,000; CF3 = $25,000; CF4 = $30,000;
CF5 = $35,000
Set I = 13%
Solve for NPVA = $3,659.68
Project B
CF0 = −$50,000; CF1 = $15,000; F1 = 5
Set I = 13%
Solve for NPVB = $2,758.47
c. Project A
CF0 = −$80,000; CF1 = $15,000; CF2 = $20,000; CF3 = $25,000; CF4 = $30,000;
CF5 = $35,000
Solve for IRRA = 14.61%
Project B
CF0 = −$50,000; CF1 = $15,000; F1 = 5
Solve for IRRB = 15.24%
 d.

Data for NPV Profiles

NPV
Discount Rate A B
0% $45,000 $25,000
13% $3,655 2,755
14.6% 0 —
15.2% — 0

Intersection—approximately 14%
If cost of capital is above 14%, conflicting rankings occur.
The calculator solution is 13.87%.
e. Both projects are acceptable. Both have similar payback periods, positive NPVs, and equivalent IRRs
that are greater than the cost of capital. Although Project B has a slightly higher IRR, the rates are
very close. Because Project A has a higher NPV, accept Project A.

P10-26. Integrative—Multiple IRRs

LG 6; Basic
a. First the project does not have an initial cash outflow. It has an inflow, so the payback is immediate.
However, there are cash outflows in later years. After 2 years, the project’s outflows are greater than
its inflows, but that reverses in year 3. The oscillating cash flows (positive-negative-positive-negative-
positive) make it difficult to even think about how the payback period should be defined.

b. CF0 = $200,000, CF1 = −920,000, CF2 = $1,582,000, CF3 = −$1,205,200, CF4 = $343,200
Set I = 0%; Solve for NPV = $0.00
Set I = 5%; Solve for NPV = −$15.43
Set I = 10%; Solve for NPV = $0.00
Set I = 15%; Solve for NPV = $6.43
Set I = 20%; Solve for NPV = $0.00
 Set I = 25%; Solve for NPV = −$7.68
Set I = 30%; Solve for NPV = $0.00
Set I = 35%, Solve for NPV = $39.51
c. There are multiple IRRs because there are several discount rates at which the NPV is zero.
d. It would be difficult to use the IRR approach to answer this question because it is not clear which IRR
should be compared to each cost of capital. For example, at 5%, the NPV is negative, so the project
would be rejected. However, at a higher 15% discount rate, the NPV is positive, and the project would
be accepted.
e. It is best simply to use NPV in a case where there are multiple IRRs due to the changing signs of the
cash flows.

P10-27. Integrative—Conflicting Rankings

LG 3, 4, 5; Intermediate
a. Plant Expansion
CF0 = −$3,500,000, CF1 = 1,500,000, CF2 = $2,000,000, CF3 = $2,500,000,
CF4 = $2,750,000
Set I = 20%; Solve for NPV = $1,911,844.14
Solve for IRR = 43.70%
CF1 = 1,500,000, CF2 = $2,000,000, CF3 = $2,500,000, CF4 = $2,750,000
Set I = 20%; Solve for NPV = $5,411,844.14 (This is the PV of the cash inflows.)
PI = $5,411,844.14  $3,500,000 = 1.55
Product Introduction
CF0 = −$500,000, CF1 = 250,000, CF2 = $350,000, CF3 = $375,000, CF4 = $425,000
Set I = 20%; Solve for NPV = $373,360.34
Solve for IRR = 52.33%
CF1 = 250,000, CF2 = $350,000, CF3 = $375,000, CF4 = $425,000
Set I = 20%; Solve for NPV = $873,360.34 (This is the PV of the cash inflows.)
PI = $873,360.34  $500,000 = 1.75
b.

Rank
Project NPV IRR PI
Plant Expansion 1 2 2
Product Introduction 2 1 1

c. The NPV is higher for the plant expansion, but both the IRR and the PI are higher for the product
introduction project. The rankings do not agree because the plant expansion has a much larger scale.
The NPV recognizes that it is better to accept a lower return on a larger project here. The IRR and PI
methods simply measure the rate of return on the project and not its scale (and therefore not how
much money in total the firm makes from each project).
d. Because the NPV of the plant expansion project is higher, the firm’s shareholders would be better off
if the firm pursued that project, even though it has a lower rate of return.
P10-28. Ethics problem
LG 1, 6; Intermediate
Year LED Project Solar Project
0 –$4,200,000 –$500,000
1 700,000 60,000
2 700,000 60,000
3 700,000 60,000
4 700,000 60,000
5 1,000,000 60,000
6 700,000 60,000
7 700,000 60,000
8 700,000 60,000
9 700,000 60,000
10 700,000 60,000
a) LED project
CF0 = −$4,200,000; C01 = $700,000; F01 =  C02 = $1,000,000; C03 = $700,000; F02 = 5
I = 10
Solve for NPVLED = $287,473.37
SOLAR project
CF0 = −$500,000; C01 = $60,000; F01 = 10
I = 10
Solve for NPVSolar = −$131,325.97
Because the NPV of LED project is positive, the company should undertake LED project.
b) Combined project
NPVCombined = NPVLED + NPVSolar
= $287,473.37 + (−$131,325.97)
= $156,147.40
Even though NPV of the combined project is positive, the company should not take the combined project.
NPV of the LED project is $287,473.37. If the company undertakes combined project, NPV decreases by
−$131,325.97 (NPV of the Solar project.) Hence, it should undertake only the LED project and not the
combined project.

c) If Diane agrees to combining the two projects into a single proposal, the company would not be
maximizing its NPV; on the other hand, if she does not agree to combining the projects, then David would
not be able to curry favor with his boss. It would not be ethical for Diane to accept David’s proposal of
rolling two projects into one as this leads to reduction in the overall NPV of the company. The company
would be better off by accepting only the LED project and rejecting the Solar project. which has a negative
NPV.
◼ Case
Case studies are available on MyFinanceLab.

Making Norwich Tool’s Lathe Investment Decision

The student is faced with a typical capital budgeting situation in Chapter 10’s case. Norwich Tool must select one
of two lathes that have different initial investments and cash inflow patterns. After calculating both unsophisticated
and sophisticated capital budgeting techniques, the student must reevaluate the decision by taking into account the
higher risk of one lathe.

a. Payback period
Lathe A:
Years 1−4 = $644,000
Payback = 4 years + ($16,000  $450,000) = 4.04 years
Lathe B:
Years 1−3 = $304,000
Payback = 3 years + ($56,000  $86,000) = 3.65 years
Lathe A will be rejected because the payback is longer than the 4-year maximum accepted, and Lathe B is
accepted because the project payback period is less than the 4-year payback cutoff.

b. 1. NPV

Discount Lathe A Lathe B

Year Rate Cash Flow PV Cash Flow PV
0 13% −$660,000 $58,132.88 −$360,000 $43,483.24
1 128,000 $88,000
2 182,000 120,000
3 166,000 96,000
4 168,000 86,000
5 450,000 207,000
2. IRR
Lathe A
$128,000 $182,000 $166,000 $168,000 $450,000
$0 = + + + + − $660,000
(1 + IRR)1 (1 + IRR)2 (1 + IRR)3 (1 + IRR) 4 (1 + IRR) 5
IRR = 15.95%
Lathe B
$88,000 $120,000 $96,000 $86,000 $207,000
$0 = + + + + − $360,000
(1 + IRR) (1 + IRR)
1 2
(1 + IRR) (1 + IRR)
3 4
(1 + IRR) 5
IRR = 17.34%
Under the NPV rule, both lathes are acceptable because the NPVs for A and B are greater than 0. Lathe A
ranks ahead of B because it has a larger NPV. The same accept decision applies to both projects with the
IRR because both IRRs are greater than the 13% cost of capital. However, the ranking reverses with the
17.34% IRR for B being greater than the 15.95% IRR for Lathe A.
c. Summary

Lathe A Lathe B
 Payback period 4.04 years 3.65 years
NPV $58,133 $43,483
IRR 15.95% 

Both projects have positive NPVs and IRRs above the firm’s cost of capital. Lathe A, however, exceeds the
maximum payback period requirement. Because it is so close to the 4-year maximum
and this is an unsophisticated capital budgeting technique, Lathe A should not be eliminated from
consideration on this basis alone, particularly because it has a much higher NPV.
If the firm has unlimited funds, it should choose all projects with positive NPVs in order to maximize
shareholder value. If the firm is subject to capital rationing, Lathe B, with its shorter payback period and
higher IRR, should be chosen. The IRR considers the relative size of the investment, which is important in a
capital rationing situation.

d. To create an NPV profile, it is best to have at least three NPV data points. To create the third point an 8%
discount rate was arbitrarily chosen. With the 8% rate, the NPV for Lathe A is $176,078, and the NPV for
Lathe B is $104,663.

Lathe B is preferred over Lathe A based on the IRR. However, as can be seen in the NPV profile,
to the left of the crossover point of the two lines Lathe A is preferred. The underlying cause of this conflict in
rankings arises from the reinvestment assumption of NPV versus IRR. NPV assumes the intermediate cash
flows are reinvested at the cost of capital, while the IRR has cash flows being reinvested at the IRR. The
difference in these two rates and the timing of the cash flows will determine the crossover point.

e. On a theoretical basis, Lathe A should be preferred because of its higher NPV and thus its known impact on
shareholder wealth. From a practical perspective, Lathe B may be selected due to its higher IRR and its faster
payback. This difference results from managers’ preferences for evaluating decisions based on percent returns
rather than dollar returns and on the desire to get a return of cash flows as quickly as possible.