Discuss NPV and IRR in terms of conflicting rankings and the theoret-

LG 6 Discuss NPV and IRR in terms of conflicting rankings and the theoret-

ical and practical strengths of each approach. Conflicting rankings of projects frequently emerge from NPV and IRR as a result of differences in the reinvest- ment rate assumption, as well as the magnitude and timing of cash flows. NPV assumes reinvestment of intermediate cash inflows at the more conservative cost of capital; IRR assumes reinvestment at the project’s IRR. On a purely theo- retical basis, NPV is preferred over IRR because NPV assumes the more con- servative reinvestment rate and does not exhibit the mathematical problem of multiple IRRs that often occurs when IRRs are calculated for nonconventional cash flows. In practice, the IRR is more commonly used because it is consistent with the general preference of business professionals for rates of return, and cor- porate financial analysts can identify and resolve problems with the IRR before decision makers use it.

Opener-in-Review

The chapter opener described a mining project that had a project NPV of $75 million and an IRR of 20%.

a. Based on the facts that the NPV is positive and the IRR is 20%, what can you infer about Genco’s cost of capital? Is it more or less than 20%?

b. Expanding the firm’s mining operations in Mexico takes $149 million. Suppose the expansion project will generate a level cash flow (an annuity) for 7 years. If the payback period is 3.6 years, what is the annual cash inflow produced by the expansion project?

c. Calculate the NPV and the IRR of the project given your answer to part b and a

9% cost of capital for Genco.

PART 5

Long-Term Investment Decisions

Self-Test Problem (Solutions in Appendix)

LG 2 LG 3 ST10–1 All techniques with NPV profile—Mutually exclusive projects Fitch Industries LG

is in the process of choosing the better of two equal-risk, mutually exclusive capital 4 LG 5 LG 6 expenditure projects—M and N. The relevant cash flows for each project are shown

in the following table. The firm’s cost of capital is 14%.

Project M

Project N

Initial investment (CF 0 )

Year (t)

Cash inflows (CF t )

a. Calculate each project’s payback period. b. Calculate the net present value (NPV) for each project. c. Calculate the internal rate of return (IRR) for each project. d. Summarize the preferences dictated by each measure you calculated, and

indicate which project you would recommend. Explain why. e. Draw the net present value profiles for these projects on the same set of

axes, and explain the circumstances under which a conflict in rankings might exist.

Warm-Up Exercises All problems are available in

LG 2 E10–1 Elysian Fields, Inc., uses a maximum payback period of 6 years and currently must choose between two mutually exclusive projects. Project Hydrogen requires an ini-

tial outlay of $25,000; project Helium requires an initial outlay of $35,000. Using the expected cash inflows given for each project in the following table, calculate each project’s payback period. Which project meets Elysian’s standards?

Expected cash inflows

Year

Hydrogen

Helium

CHAPTER 10

Capital Budgeting Techniques

LG 3 E10–2 Herky Foods is considering acquisition of a new wrapping machine. The initial investment is estimated at $1.25 million, and the machine will have a 5-year life

with no salvage value. Using a 6% discount rate, determine the net present value (NPV) of the machine given its expected operating cash inflows shown in the following table. Based on the project’s NPV, should Herky make this investment?

Year

Cash inflow

LG 3 E10–3 Axis Corp. is considering investment in the best of two mutually exclusive projects. Project Kelvin involves an overhaul of the existing system; it will cost $45,000 and generate cash inflows of $20,000 per year for the next 3 years. Project Thompson involves replacement of the existing system; it will cost $275,000 and generate cash inflows of $60,000 per year for 6 years. Using an 8% cost of capital, calculate each project’s NPV, and make a recommendation based on your findings.

LG 4 E10–4 Billabong Tech uses the internal rate of return (IRR) to select projects. Calculate the IRR for each of the following projects and recommend the best project based on this measure. Project T-Shirt requires an initial investment of $15,000 and generates cash inflows of $8,000 per year for 4 years. Project Board Shorts requires an initial investment of $25,000 and produces cash inflows of $12,000 per year for 5 years.

LG 4 LG 5 E10–5 Cooper Electronics uses NPV profiles to visually evaluate competing projects. Key data for the two projects under consideration are given in the following table. Using these data, graph, on the same set of axes, the NPV profiles for each project using discount rates of 0%, 8%, and the IRR.

Terra

Firma

Initial investment

Operating cash inflows

Problems All problems are available in

LG 2 P10–1 Payback period Jordan Enterprises is considering a capital expenditure that requires an initial investment of $42,000 and returns after-tax cash inflows of $7,000 per year for 10 years. The firm has a maximum acceptable payback period of 8 years.

a. Determine the payback period for this project.

PART 5

Long-Term Investment Decisions

LG 2 P10–2 Payback comparisons Nova Products has a 5-year maximum acceptable payback period. The firm is considering the purchase of a new machine and must choose

between two alternative ones. The first machine requires an initial investment of $14,000 and generates annual after-tax cash inflows of $3,000 for each of the next

7 years. The second machine requires an initial investment of $21,000 and provides an annual cash inflow after taxes of $4,000 for 20 years. a. Determine the payback period for each machine. b. Comment on the acceptability of the machines, assuming that they are inde-

pendent projects. c. Which machine should the firm accept? Why? d. Do the machines in this problem illustrate any of the weaknesses of using pay-

back? Discuss.

LG 2 P10–3 Choosing between two projects with acceptable payback periods Shell Camping Gear, Inc., is considering two mutually exclusive projects. Each requires an initial

investment of $100,000. John Shell, president of the company, has set a maximum payback period of 4 years. The after-tax cash inflows associated with each project are shown in the following table:

Cash inflows (CF t )

Year

Project A

Project B

a. Determine the payback period of each project.

b. Because they are mutually exclusive, Shell must choose one. Which should the

company invest in? c. Explain why one of the projects is a better choice than the other.

Personal Finance Problem

LG 2 P10–4 Long-term investment decision, payback method Bill Williams has the opportunity to invest in project A that costs $9,000 today and promises to pay annual end-of-

year payments of $2,200, $2,500, $2,500, $2,000, and $1,800 over the next 5 years. Or, Bill can invest $9,000 in project B that promises to pay annual end-of-year pay- ments of $1,500, $1,500, $1,500, $3,500, and $4,000 over the next 5 years.

a. How long will it take for Bill to recoup his initial investment in project A? b. How long will it take for Bill to recoup his initial investment in project B? c. Using the payback period, which project should Bill choose? d. Do you see any problems with his choice?

LG 3 P10–5 NPV Calculate the net present value (NPV) for the following 20-year projects. Comment on the acceptability of each. Assume that the firm has an opportunity cost

of 14%.

a. Initial investment is $10,000; cash inflows are $2,000 per year. b. Initial investment is $25,000; cash inflows are $3,000 per year.

CHAPTER 10

Capital Budgeting Techniques

LG 3 P10–6 NPV for varying costs of capital Dane Cosmetics is evaluating a new fragrance- mixing machine. The machine requires an initial investment of $24,000 and will

generate after-tax cash inflows of $5,000 per year for 8 years. For each of the costs of capital listed, (1) calculate the net present value (NPV), (2) indicate whether to accept or reject the machine, and (3) explain your decision.

a. The cost of capital is 10%. b. The cost of capital is 12%. c. The cost of capital is 14%.

LG 3 P10–7 Net present value—Independent projects Using a 14% cost of capital, calculate the net present value for each of the independent projects shown in the following table,

and indicate whether each is acceptable.

Project A

Project B

Project C

Project D Project E

$950,000 $80,000 Year (t)

Initial investment (CF 0 )

Cash inflows (CF t )

LG 3 P10–8 NPV Simes Innovations, Inc., is negotiating to purchase exclusive rights to manu- facture and market a solar-powered toy car. The car’s inventor has offered Simes the choice of either a one-time payment of $1,500,000 today or a series of five year-end payments of $385,000.

a. If Simes has a cost of capital of 9%, which form of payment should it choose? b. What yearly payment would make the two offers identical in value at a cost of

capital of 9%? c. Would your answer to part a of this problem be different if the yearly payments

were made at the beginning of each year? Show what difference, if any, that change in timing would make to the present value calculation.

d. The after-tax cash inflows associated with this purchase are projected to amount to $250,000 per year for 15 years. Will this factor change the firm’s decision about how to fund the initial investment?

LG 3 P10–9 NPV and maximum return

A firm can purchase a fixed asset for a $13,000 initial investment. The asset generates an annual after-tax cash inflow of $4,000 for 4 years. a. Determine the net present value (NPV) of the asset, assuming that the firm has a 10% cost of capital. Is the project acceptable?

b. Determine the maximum required rate of return (closest whole-percentage rate) that the firm can have and still accept the asset. Discuss this finding in light of

PART 5

Long-Term Investment Decisions

LG 3 P10–10 NPV—Mutually exclusive projects Hook Industries is considering the replacement of one of its old drill presses. Three alternative replacement presses are under consid-

eration. The relevant cash flows associated with each are shown in the following table. The firm’s cost of capital is 15%.

Press A

Press B

Press C

Initial investment (CF 0 )

Year (t)

Cash inflows (CF t )

a. Calculate the net present value (NPV) of each press. b. Using NPV, evaluate the acceptability of each press. c. Rank the presses from best to worst using NPV. d. Calculate the profitability index (PI) for each press. e. Rank the presses from best to worst using PI.

Personal Finance Problem

LG 3 P10–11 Long-term investment decision, NPV method Jenny Jenks has researched the finan- cial pros and cons of entering into an elite MBA program at her state university. The tuition and needed books for a master’s program will have an upfront cost of $100,000. On average, a person with an MBA degree earns an extra $20,000 per year over a business career of 40 years. Jenny feels that her opportunity cost of cap- ital is 6%. Given her estimates, find the net present value (NPV) of entering this MBA program. Are the benefits of further education worth the associated costs?

LG 2 LG 3 P10–12 Payback and NPV Neil Corporation has three projects under consideration. The cash flows for each project are shown in the following table. The firm has a 16% cost of capital.

Project A

Project B

Project C

Initial investment (CF 0 )

Year (t)

Cash inflows (CF t )

CHAPTER 10

Capital Budgeting Techniques

a. Calculate each project’s payback period. Which project is preferred according to this method?

b. Calculate each project’s net present value (NPV). Which project is preferred according to this method?

c. Comment on your findings in parts a and b, and recommend the best project. Explain your recommendation.

LG 3 P10–13 NPV and EVA

A project costs $2.5 million up front and will generate cash flows in perpetuity of $240,000. The firm’s cost of capital is 9%. a. Calculate the project’s NPV. b. Calculate the annual EVA in a typical year.

c. Calculate the overall project EVA and compare to your answer in part a.

LG 4 P10–14 Internal rate of return For each of the projects shown in the following table, calcu- late the internal rate of return (IRR). Then indicate, for each project, the maximum

cost of capital that the firm could have and still find the IRR acceptable.

Project A

Project B

Project C Project D

Initial investment (CF 0 )

Year (t)

Cash inflows (CF t )

LG 4 P10–15 IRR—Mutually exclusive projects Bell Manufacturing is attempting to choose the better of two mutually exclusive projects for expanding the firm’s warehouse capacity. The relevant cash flows for the projects are shown in the following table. The firm’s cost of capital is 15%.

Project X

Project Y

Initial investment (CF 0 )

Year (t)

Cash inflows (CF t )

a. Calculate the IRR to the nearest whole percent for each of the projects.

b. Assess the acceptability of each project on the basis of the IRRs found in part a.

PART 5

Long-Term Investment Decisions

Personal Finance Problem

LG 4 P10–16 Long-term investment decision, IRR method Billy and Mandy Jones have $25,000 to invest. On average, they do not make any investment that will not return at least 7.5% per year. They have been approached with an investment opportunity that requires $25,000 upfront and has a payout of $6,000 at the end of each of the next

5 years. Using the internal rate of return (IRR) method and their requirements, determine whether Billy and Mandy should undertake the investment.

LG 4 P10–17 IRR, investment life, and cash inflows Oak Enterprises accepts projects earning more than the firm’s 15% cost of capital. Oak is currently considering a 10-year

project that provides annual cash inflows of $10,000 and requires an initial invest- ment of $61,450. ( Note: All amounts are after taxes.)

a. Determine the IRR of this project. Is it acceptable? b. Assuming that the cash inflows continue to be $10,000 per year, how many

additional years would the flows have to continue to make the project acceptable (that is, to make it have an IRR of 15%)?

c. With the given life, initial investment, and cost of capital, what is the minimum

annual cash inflow that the firm should accept?

LG 3 LG 4 P10–18 NPV and IRR Benson Designs has prepared the following estimates for a long- term project it is considering. The initial investment is $18,250, and the project is expected to yield after-tax cash inflows of $4,000 per year for 7 years. The firm has

a 10% cost of capital. a. Determine the net present value (NPV) for the project. b. Determine the internal rate of return (IRR) for the project. c. Would you recommend that the firm accept or reject the project? Explain your

answer.

LG 3 LG 4 P10–19 NPV, with rankings Botany Bay, Inc., a maker of casual clothing, is considering four projects. Because of past financial difficulties, the company has a high cost of capital at 15%. Which of these projects would be acceptable under those cost circumstances?

Project A

Project B

Project C Project D

Initial investment (CF 0 )

Year (t)

Cash inflows (CF t )

a. Calculate the NPV of each project, using a cost of capital of 15%. b. Rank acceptable projects by NPV. c. Calculate the IRR of each project, and use it to determine the highest cost of

capital at which all of the projects would be acceptable.

CHAPTER 10

Capital Budgeting Techniques

LG 2 LG 3 P10–20 All techniques, conflicting rankings Nicholson Roofing Materials, Inc., is consid- LG

ering two mutually exclusive projects, each with an initial investment of $150,000. 4 The company’s board of directors has set a maximum 4-year payback requirement

and has set its cost of capital at 9%. The cash inflows associated with the two projects are shown in the following table.

Cash inflows (CF t )

Year

Project A

Project B

a. Calculate the payback period for each project. b. Calculate the NPV of each project at 0%. c. Calculate the NPV of each project at 9%. d. Derive the IRR of each project. e. Rank the projects by each of the techniques used. Make and justify a recommen-

dation. LG 2 LG 3 P10–21 Payback, NPV, and IRR Rieger International is attempting to evaluate the feasi-

LG bility of investing $95,000 in a piece of equipment that has a 5-year life. The firm

4 has estimated the cash inflows associated with the proposal as shown in the following table. The firm has a 12% cost of capital.

Year (t)

Cash inflows (CF t )

a. Calculate the payback period for the proposed investment. b. Calculate the net present value (NPV) for the proposed investment. c. Calculate the internal rate of return (IRR), rounded to the nearest whole percent,

for the proposed investment. d. Evaluate the acceptability of the proposed investment using NPV and IRR. What

recommendation would you make relative to implementation of the project? Why?

LG 3 LG 4 P10–22 NPV, IRR, and NPV profiles Thomas Company is considering two mutually exclu- LG

sive projects. The firm, which has a 12% cost of capital, has estimated its cash flows 5 as shown in the following table.

PART 5

Long-Term Investment Decisions

Project A

Project B

Initial investment (CF 0 )

Year (t)

Cash inflows (CF t )

a. Calculate the NPV of each project, and assess its acceptability. b. Calculate the IRR for each project, and assess its acceptability. c. Draw the NPV profiles for both projects on the same set of axes. d. Evaluate and discuss the rankings of the two projects on the basis of your find-

ings in parts a, b, and c. e. Explain your findings in part d in light of the pattern of cash inflows associated

with each project.

LG 2 LG 3 P10–23 All techniques—Decision among mutually exclusive investments Pound Industries LG 4 LG

is attempting to select the best of three mutually exclusive projects. The initial 5 investment and after-tax cash inflows associated with these projects are shown in the

LG 6 following table.

Cash flows

Project A

Project B Project C

Initial investment ( CF 0 )

Cash inflows ( CF t ), t =

a. Calculate the payback period for each project. b. Calculate the net present value (NPV) of each project, assuming that the firm has

a cost of capital equal to 13%. c. Calculate the internal rate of return (IRR) for each project. d. Draw the net present value profiles for both projects on the same set of axes, and

discuss any conflict in ranking that may exist between NPV and IRR. e. Summarize the preferences dictated by each measure, and indicate which project

you would recommend. Explain why.

LG 2 LG 3 P10–24 All techniques with NPV profile—Mutually exclusive projects Projects A and B, of LG 4 LG

equal risk, are alternatives for expanding Rosa Company’s capacity. The firm’s cost 5 of capital is 13%. The cash flows for each project are shown in the following table.

LG 6 a. Calculate each project’s payback period. b. Calculate the net present value (NPV) for each project. c. Calculate the internal rate of return (IRR) for each project. d. Draw the net present value profiles for both projects on the same set of axes, and

discuss any conflict in ranking that may exist between NPV and IRR. e. Summarize the preferences dictated by each measure, and indicate which project

CHAPTER 10

Capital Budgeting Techniques

Project A

Project B

Initial investment (CF 0 )

Year (t)

Cash inflows (CF t )

LG 6 P10–25 Integrative—Multiple IRRs Froogle Enterprises is evaluating an unusual invest- ment project. What makes the project unusual is the stream of cash inflows and out-

flows shown in the following table:

Year

Cash flow

0 $ 200,000 1 - 920,000 2 1,582,000

3 - 1,205,200 4 343,200

a. Why is it difficult to calculate the payback period for this project? b. Calculate the investment’s net present value at each of the following discount

rates: 0%, 5%, 10%, 15%, 20%, 25%, 30%, 35%. c. What does your answer to part b tell you about this project’s IRR? d. Should Froogle invest in this project if its cost of capital is 5%? What if the cost

of capital is 15%? e. In general, when faced with a project like this, how should a firm decide whether

to invest in the project or reject it? LG 3 LG 4 P10–26 Integrative—Conflicting Rankings The High-Flying Growth Company (HFGC) has

LG been growing very rapidly in recent years, making its shareholders rich in the process.

5 The average annual rate of return on the stock in the last few years has been 20%, and HFGC managers believe that 20% is a reasonable figure for the firm’s cost of capital.

To sustain a high growth rate, the HFGC CEO argues that the company must con- tinue to invest in projects that offer the highest rate of return possible. Two projects are currently under review. The first is an expansion of the firm’s production capacity, and the second project involves introducing one of the firm’s existing products into a new market. Cash flows from each project appear in the following table.

a. Calculate the NPV, IRR, and PI for both projects. b. Rank the projects based on their NPVs, IRRs, and PIs. c. Do the rankings in part b agree or not? If not, why not? d. The firm can only afford to undertake one of these investments, and the CEO

favors the product introduction because it offers a higher rate of return (that is, a higher IRR) than the plant expansion. What do you think the firm should do?

PART 5

Long-Term Investment Decisions

Year

Plant expansion

Product introduction

LG 1 LG 6 P10–27 ETHICS PROBLEM Gap, Inc., is trying to incorporate human resource and supplier considerations into its management decision making. Here is Gap’s report of find-

ings from a recent Social Responsibility Report:

Because factory owners sometimes try to hide violations, Gap emphasizes training for factory managers. However, due to regional differences, the training varies from one site to another. The report notes that 10 to 25 percent of workers in China, Taiwan, and Saipan have been harassed and humiliated. Less than half of the facto- ries in sub-Saharan Africa have adequate worker safety regulations and infrastruc- ture. In Mexico, Latin America, and the Caribbean, 25 to 50 percent of the suppliers fail to pay even the minimum wage.

Calvert Group, Ltd., a mutual fund family that focuses on “socially responsible investing,” had this to say about the impact of Gap’s report:

With revenues of $15.9 billion and over 300,000 employees worldwide, Gap leads the U.S. apparel sector and has contracts with over 3,000 factories globally. Calvert has been in dialogue with Gap for about five years, the last two as part of the Working Group.

Gap’s supplier monitoring program focuses on remediation, because its sup- pliers produce for multiple apparel companies and would likely move their capacity to different clients rather than adopt conditions deemed too demanding. About one- third of the factories Gap examined comfortably met Gap’s criteria, another third had barely acceptable conditions, and the final third missed the minimum standards. Gap terminated contracts with 136 factories where it found conditions to be beyond remediation.

Increased transparency and disclosure are crucial in measuring a company’s commitment to raising human rights standards and improving the lives of workers. Gap’s report is an important first step in the direction of a model format that other companies can adapt. 8

If Gap were to aggressively pursue renegotiations with suppliers, based on this report, what is the likely effect on Gap’s expenses in the next 5 years? In your opinion, what would be the impact on its stock price in the immediate future? After

10 years?

8. www.calvert.com/news_newsArticle.asp?article=4612&image=cn.gif&keepleftnav=Calvert+News

CHAPTER 10

Capital Budgeting Techniques

Spreadsheet Exercise

The Drillago Company is involved in searching for locations in which to drill for oil. The firm’s current project requires an initial investment of $15 million and has an estimated life of 10 years. The expected future cash inflows for the project are as shown in the following table:

Year

Cash inflows

The firm’s current cost of capital is 13%. TO DO

Create a spreadsheet to answer the following:

a. Calculate the project’s net present value (NPV). Is the project acceptable under

the NPV technique? Explain. b. Calculate the project’s internal rate of return (IRR). Is the project acceptable

under the IRR technique? Explain. c. In this case, did the two methods produce the same results? Generally, is there a

preference between the NPV and IRR techniques? Explain. d. Calculate the payback period for the project. If the firm usually accepts projects

that have payback periods between 1 and 7 years, is this project acceptable?

Visit www.myfinancelab.com for Chapter Case: Making Norwich Tool’s Lathe Investment Decision, Group Exercises, and numerous online resources.

11 Learning Goals