FIN60204 – CORPORATE FINANCE

TUTORIAL QUESTIONS

TOPIC 3 – CHAPTER 5 (NET PRESENT VALUE & OTHER INVESTMENT RULES)

QUESTIONS & PROBLEMS

1. Fuji Software Inc. has the following mutually exclusive projects.

a. Suppose Fuji’s payback period cutoff is 2 years. Which of these 2 projects
should be chosen?
b. Suppose Fuji uses the NPV rule to rank these projects. Which project
should be chosen if the appropriate discount rate is 15%?

Year Project A ($) Project B ($)

0 -15,000 -18,000

1 9,500 10,500

2 6,000 7,000

3 2,400 6,000

Answer

Q1-a)

The payback period is the time that it takes for the cumulative undiscounted
cash inflows to equal the initial investment.

Accept Shortest payback period

Reject Longer payback period
Comparison Choose the shortest period

Steps:
1) Calculate cumulative cash flows
2) Find the intersection point (positive & negative value) based on cumulative
cash flows.
3) Divide cumulative cash flows with next year cash flow. Ignore negative sign
when calculate.

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Project A:

Year Project A ($) Cumulative Cash Flows ($)

0 -15,000 -15,000

1 9,500 -5,500

2 6,000 500

3 2,400 2,900

Payback period = 1 + ($5,500 / $6,000)

Payback period = 1.92 years

Project B:

Year Project B ($) Cumulative Cash flows ($)

0 -18,000 -18,000

1 10,500 -7,500

2 7,000 -500

3 6,000 5,500

Payback period = 2 + ($500 / $6,000)

Payback period = 2.083 years

Since project A has a shorter payback period than project B has, the company
should choose project A. In fact, the firm cut off period is 2 years. Therefore,
we should reject Project B because exceeded this cut off period.

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TUTORIAL QUESTIONS

Q1-b)

Discount each project’s cash flows at 15 percent. Choose the project with the
highest NPV.

Accept NPV > $0 (positive figure)

Reject NPV < $0 (negative figure)
Comparison Choose the highest NPV

Project A:

NPV = –$15,000 + $9,500 / 1.15 + $6,000 / 1.152 + $2,400 / 1.153

NPV = –$624.23

CF0 C01 F01 C02 F02 C03 F03 I/Y CPT NPV

-15,000 9,500 1 6,000 1 2,400 1 15 –$624.23

Project B:

NPV = –$18,000 + $10,500 / 1.15 + $7,000 / 1.152 + $6,000 / 1.153

NPV = $368.54

CF0 C01 F01 C02 F02 C03 F03 I/Y CPT NPV

-18,000 10,500 1 7,000 1 6,000 1 15 $368.54

The firm should choose Project B since it has a higher NPV than Project A. In
fact, project A is negative NPV therefore the firm should reject the project.

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TUTORIAL QUESTIONS

2. An investment project provides cash inflows of $840 per year for 8 years. What
is the project payback period if the initial cost is $3,200? What if the initial cost
is $4,800? What if it is $7,300?

Answer

To calculate the payback period, we need to find the time that the project has
taken to recover its initial investment. The cash flows in this problem are an
annuity, so the calculation is simpler. So the initial cost divide with annuity.

If the initial cost is $3,200, the payback period is:

Payback = $3,200 / 840 = 3.81 years

For an initial cost of $4,800, the payback period is:

Payback = $4,800 / $840 = 5.71 years

For an initial cost of $7,300, the payback period is:

Payback = $7,300 / $840 = 8.69 years

For this initial cost, the project never pays back because its exceeded the cash
flow of 8 years. This answer does not make sense since the cash flows stop after
eight years, so there is no payback period.

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TUTORIAL QUESTIONS

3. What is the net present value of a project with the following cash flows and a
required return of 12%?

Answer

4. What is the net present value of a project that has an initial cash outflow of
$12,670 and the following cash inflows? The required return is 11.5%.

Answer

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TUTORIAL QUESTIONS

5. A project will produce cash inflows of $1,750 a year for four years. The project
initially costs $10,600 to get started. In year five, the project will be closed and
as a result should produce a cash inflow of $8,500. What is the net present value
of this project if the required rate of return is 13.75%?

Answer

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TUTORIAL QUESTIONS

6. Stone Sour Inc., has a project with the following cash flows. The company
evaluates all projects y applying the IRR rule. If the appropriate interest rate is
9%, should the company accept the project?

Year Cash flows ($)

0 -20,000

1 8,500

2 10,200

3 6,200

Answer

Accept IRR > I (discount rate)

Reject IRR < I (discount rate)
Comparison Choose the highest IRR
Notes • IRR to find what is the rate to break – even the cost, which is when
the NPV = 0
• NPV & IRR generally give the same decision. However, exceptions
applied to:
1. Non-conventional cashflow. May have negative cashflow sign.
Thus, producing two or more IRRs.
2. Mutually exclusive projects. There might have substantial
difference in the initial investments & cashflows (scale problem).
Other than that, substantial timing problem and IRR is unreliable
to rank mutually exclusive projects.

CF0 C01 F01 C02 F02 C03 F03 CPT IRR

-20,000 8,500 1 10,200 1 6,200 1 12.41%

The IRR is the interest rate that makes the NPV of the project equal to zero.
So, the equation that defines the IRR for this project is:

0 = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + C3 / (1 + IRR)3

0 = –$20,000 + $8,500/(1 + IRR) + $10,200/(1 + IRR)2 + $6,200/(1 + IRR)3

Since the IRR is greater than the required return, we would accept the project.

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TUTORIAL QUESTIONS

7. Compute the internal rate of return for the cash flows of the following 2
projects:

Year Project A ($) Project B ($)

0 -5,300 -2,900

1 2,000 1,100

2 2,800 1,800

3 1,600 1,200

Answer

Project A

CF0 C01 F01 C02 F02 C03 F03 CPT IRR

-5,300 1,100 1 1,800 1 1,200 1 10.38%

The IRR is the interest rate that makes the NPV of the project equal to zero. So,
the equation that defines the IRR for this Project A is:

0 = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + C3 / (1 + IRR)3

0 = –$5,300 + $2,000/(1 + IRR) + $2,800/(1 + IRR)2 + $1,600/(1 + IRR)3

Project B
CF0 C01 F01 C02 F02 C03 F03 CPT IRR

-2,900 1,100 1 1,800 1 1,200 1 19.16%

And the IRR for Project B is:

0 = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + C3 / (1 + IRR)3

0 = –$2,900 + $1,100/(1 + IRR) + $1,800/(1 + IRR)2 + $1,200/(1 + IRR)3

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TUTORIAL QUESTIONS

8. Suppose the following 2 independent investment opportunities are available

to Greenplain Inc. The appropriate discount rate is 10%.

a. Compute the profitability index for each of the 2 projects.

b. Which project(s) should Greenplain accept based on the profitability
index rule?

Year Project Alpha ($) Project Beta ($)

0 -2,300 -3,900

1 1,200 800

2 1,100 2,300

3 900 2,900

Answer

Q8-a)

The profitability index is the present value of the future cash flows divided by
the initial cost.

Profitability Index (PI)

Accept PI > 1.00 (able to cover its cost)
Reject PI < 1.00 (unable to cover its cost)
Comparison Choose the highest PI.
Formula n
CFt
 (1 + r ) t
PI = t =1
PI =
Total PV of Future Cash Flows
CF0
or Initial Investent

Steps (using financial calculator):

1. Compute NPV
2. Add back initial investment (Y0)
3. Divide initial investment (ignore negative sign)

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Method using formula

Project Alpha, profitability index (PI):

PIAlpha = [$1,200 / 1.10 + $1,100 / 1.102 + $900 / 1.103] / $2,300 = 1.164

Project Beta , profitability index (PI):

PIBeta = [$800 / 1.10 + $2,300 / 1.102 + $2,900 / 1.103] / $3,900 = 1.233

Q8-b)

According to the profitability index, you would accept Project Beta. However,
remember the profitability index rule can lead to an incorrect decision when
ranking mutually exclusive projects.

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TUTORIAL QUESTIONS

9. Consider the following cash flows on 2 mutually exclusive projects for the
Phuket Recreation Corp. (PRC). Both projects require an annual return of 14%.
As s financial analyst for PRC, you are asked the following questions:

a. If your decision rule is to accept the project with greater IRR, which
project should you choose?
b. Because you are fully aware of the IRR rule’s scale problem, you
calculate the incremental IRR for the cash flows. Based on your
computation, which project should you choose?
c. To be prudent, you compute the NPV for both projects. Which project
should you choose? Is it consistent with the incremental IRR rule?

Year Deepwater Fishing ($) New Submarine Ride ($)

0 -950,000 -1,850,000

1 370,000 900,000

2 510,000 800,000

3 420,000 750,000

Answer

Q9-a)

The IRR is the interest rate that makes the NPV of the project equal to zero.
So, the IRR for each project is:

Deepwater Fishing IRR:

0 = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + C3 / (1 + IRR)3

0 = –$950,000+$370,000/(1+IRR)+$510,000/(1+IRR)2 +$420,000/(1 + IRR)3

IRR = 17.07%

CF0 C01 F01 C02 F02 C03 F03 CPT IRR

-950,000 370,000 1 510,000 1 42,000 1 17.07%

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Submarine Ride IRR:

0 = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + C3 / (1 + IRR)3

0 = –$1,850,000+$900,000/(+IRR)+$800,000/(1+IRR)2+$750,000/(1+IRR)3

IRR = 16.03%

CF0 C01 F01 C02 F02 C03 F03 CPT IRR

-1,850,000 900,000 1 800,000 1 750,000 1 16.03%

Based on the IRR rule, the Deepwater Fishing project should be chosen
because it has the highest IRR.

Q9-b)

To calculate the incremental IRR, we subtract the smaller project’s cash flows
from the larger project’s cash flows. In this case, we subtract the deepwater
fishing cash flows from the submarine ride cash flows. The incremental IRR is
the IRR of these incremental cash flows. So, the incremental cash flows of the
submarine ride are:

Year 0 Year 1 Year 2 Year 3

Submarine Ride –$1,850,000 $900,000 $800,000 $750,000
Minus Deepwater Fishing –950,000 370,000 510,000 420,000
Incremental Cash flows –$900,000 $530,000 $290,000 $330,000

Setting the present value of these incremental cash flows equal to zero, we
find the incremental IRR is:

0 = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + C3 / (1 + IRR)3

0 = –$900,000+$530,000/(1 + IRR) + $290,000 / (1 + IRR)2 + $330,000/(1 + IRR)3

Incremental IRR = 14.79%

CF0 C01 F01 C02 F02 C03 F03 CPT IRR

-900,000 530,000 1 290,000 1 330,000 1 14.79%

For investing-type projects, accept the larger project when the incremental
IRR is greater than the discount rate. Since the incremental IRR, 14.79 percent,
is greater than the required rate of return of 14 percent, choose the Submarine
Ride project.

Note that this is not the choice when evaluating only the IRR of each project.
The IRR decision rule is flawed because there is a scale problem. That is, the
submarine ride has a greater initial investment than does the Deepwater
Fishing project. This problem is corrected by calculating the IRR of the
incremental cash flows, or by evaluating the NPV of each project.

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Q9-c)

The NPV is the sum of the present value of the cash flows from the project, so
the NPV of each project will be:

Deepwater fishing:

NPV = –$950,000 + $370,000 / 1.14 + $510,000 / 1.142 + $420,000 / 1.143

NPV = $50,477.88

CF0 C01 F01 C02 F02 C03 F03 I/Y CPT NPV

-950,000 370,000 1 510,000 1 420,000 1 14 $50,477.88

Submarine ride:

NPV = –$1,850,000 + $900,000 / 1.14 + $800,000 / 1.142 + $750,000 / 1.143

NPV = $61,276.34

CF0 C01 F01 C02 F02 C03 F03 I/Y CPT NPV

-1,850,000 900,000 1 800,000 1 750,000 1 14 $61,276.34

Since the NPV of the submarine ride project is greater than the NPV of the Deepwater
Fishing project, choose the Submarine Ride project. The incremental IRR rule is always
consistent with the NPV rule.

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TUTORIAL QUESTIONS

10. Consider the following cash flows of 2 mutually exclusive projects for AZ
Motorcars. Assume the discount rate is 10%.

a. Based on the payback period, which project should be accepted?

b. Based on the NPV, which project should be accepted?
c. Based on the IRR, which project should be accepted?
d. Based on the analysis, is incremental IRR analysis necessary? If yes,
please conduct the analysis.

Year AZM Mini SUV ($) AZM Full SUV ($)

0 - 450,000 - 800,000

1 320,000 350,000

2 180,000 420,000

3 150,000 290,000

Answer

Q10-a)

Year AZM Mini SUV ($) Cumulative Cash Flows ($)

0 -450,000 -450,000

1 320,000 -130,000

2 180,000 50,000

3 150,000 200,000

The payback period is the time that it takes for the cumulative undiscounted
cash inflows to equal the initial investment.

AZM Mini-SUV:

Payback period = 1+ $130,000 / $180,000 = 1.72 years

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AZM Full-SUV:

Year AZM Full SUV ($) Cumulative cash flows ($)

0 -800,000 -800,000

1 350,000 -450,000

2 420,000 -30,000

3 290,000 260,000

Payback period = 2+ $30,000 / $290,000 = 2.10 years

Since the AZM Mini SUV has a shorter payback period than the AZM Full SUV, the
company should choose the AZM Mini SUV. Remember the payback period does not
necessarily rank projects correctly.

Q10-b)

The NPV of each project is:

AZM Mini-SUV:
NPVAZM = –$450,000 + $320,000 / 1.10 + $180,000 / 1.102 + $150,000 / 1.103
NPVAZM = $102,366.64

CF0 C01 F01 C02 F02 C03 F03 I/Y CPT NPV

-450,000 320,000 1 180,000 1 150,000 1 10 $102,366.64

AZM Full-SUV:
NPVAZF = –$800,000 + $350,000 / 1.10 + $420,000 / 1.102 + $290,000 / 1.103
NPVAZF = $83,170.55

CF0 C01 F01 C02 F02 C03 F03 I/Y CPT NPV

-800,000 350,000 1 420,000 1 290,000 1 10 $83,170.55

The NPV criteria implies we accept the AZM Mini SUV because it has the highest
NPV.

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Q10-c)

AZM Mini-SUV:

The IRR is the interest rate that makes the NPV of the project equal to zero.
So, the IRR of the AZM is:

0 = –$450,000 + $320,000 / (1 + IRR) + $180,000 / (1 + IRR)2 + $150,000 / (1 + IRR)3

CF0 C01 F01 C02 F02 C03 F03 CPT IRR

-450,000 320,000 1 180,000 1 150,000 1 24.65%

IRRAZM = 24.65%

AZM Full-SUV:

And the IRR of the AZF is:

0 = –$800,000 + $350,000 / (1 + IRR) + $420,000 / (1 + IRR)2 + $290,000 / (1 + IRR)3

CF0 C01 F01 C02 F02 C03 F03 CPT IRR

-800,000 350,000 1 420,000 1 290,000 1 15.97%

IRRAZF = 15.97%

The IRR criteria implies we accept the AZM Mini SUV because it has the highest
IRR. Remember the IRR does not necessarily rank projects correctly.

Q10-d)

Incremental IRR analysis is not necessary. The AZM Mini SUV has the smallest
initial investment, and the largest NPV, so it should be accepted.

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