Chapter 7

Investment Decision Rules

Note: All problems in this chapter are available in MyFinanceLab. An asterisk (*) indicates problems with a higher level of difficulty. 1. Plan: We can compute the NPV of the project using Eq. (7.2). The cash flows are an immediate $8 million outflow followed by an annuity inflow of $5 million per year for 3 years and a discount rate of 8%. Execute: a. NPV = 8 +
5 1 1 = $4.885 million. 0.08 (1.08)3

The NPV rule dictates that you should accept this contract. b. The value of the firm will increase by $4.885 million. Evaluate: The NPV rule indicates that by making the investment, your factory will increase the value of the firm today by $4.885 million, so you should undertake the project. 2. Plan: We can compute the NPV of the project using Eq. (7.2). The cash flows are an immediate $100 million outflow followed by an annuity inflow of $30 million and a discount rate of 8%. We can compute the IRR using a financial calculator or spreadsheet or by setting the NPV equal to zero and solving for r. After we find the IRR we can compute the maximum deviation allowable in the cost of capital estimate to leave the decision unchanged by subtracting the cost of capital from the IRR. Execute: Timeline: 0 1 2 3 4

100

30
1 30 NPV = 100 1.08 0.08 = $247.22 million

30

30

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The IRR solves

1 30 100 = 0 r = 24.16%. 1+ r r

So, the cost of capital can be underestimated by 16.16% without changing the decision. Evaluate: The NPV rule indicates that by making the investment, your factory will increase the value of the firm today by $4.885 million, so you should undertake the project. The IRR is the discount rate that sets the net present value of the cash flows equal to zero. The difference between the cost of capital and the IRR tells us the amount of estimation error in the cost of capital estimate that can exist without altering the original decision. 3. Plan: We can compute the NPV of agreeing to write the book ignoring any royalty payments using Eq. (7.2). The cash flows are an immediate $10 million outflow followed by an annuity inflow of 8 million per year for 3 years and a discount rate of 10%. We can compute the NPV of the book with the royalty payments by first computing the present value of the royalties at year three. Once we compute the royalties at year 3 we can compute the present value of the royalties today and add that number to the NPV of agreeing to write the book ignoring any royalty payments. Execute: a. Timeline: 0 1 2 3

10

8
NPV = 10

8
8 1 1 0.1 (1.1)3

= $9.895 million

b. Timeline: 0 1 2 3 4 5 6

10

5(1 0.3) 5(1 03)

First calculate the PV of the royalties at year 3. The royalties are a declining perpetuity:
PV5 = 5 0.1 ( 0.3) 5 = 0.4 = 12.5 million

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so the value today is

PVroyalties = 12.5 (1.1)3 = 9.391.

Now add this to the NPV from part (a),

NPV = 9.895 + 9.391 = $503,381.

Evaluate: The NPV rule indicates that by agreeing to write the book (ignoring any royalties), you will decrease the value of the firm today by $9.895 million, and by agreeing to write the book including royalties, you will decrease the value of the firm by only $503,381 and therefore Bill should not undertake either project because both will decrease the value of the firm. *4. Plan: We can compute the NPV using Eq. (7.2), a spreadsheet on Excel, or a financial calculator. We can compute the IRR using a financial calculator or spreadsheet or by setting the NPV equal to zero and solving for r. After we find the IRR we can compute the maximum deviation allowable in the cost of capital estimate to leave the decision unchanged by subtracting the cost of capital from the IRR. We can compute the length of time that the development must last to change the decision by using a financial calculator, a spreadsheet, or by setting the NPV equal to zero and solving for n. Execute: a. NPV =
200,000 1 1 300,000 1 + 1 1 6 6 10 r r (1 + r ) (1 + r ) (1 + r ) 200,000 1 1 300,000 1 = + 1 1 6 6 0.1 (1.1) (1.1) 0.1 (1.1)10 = $169,482

NPV > 0, so the company should take the project. b. Setting the NPV = 0 and solving for r (using a spreadsheet) the answer is IRR = 12.66%. So if the estimate is too low by 2.66%, the decision will change from accept to reject. c. The new timeline is 0 1 2 3 N N+1 N + 10

200,000 200,000 200,000

NPV = 200,000 1 1 N r (1 + r )

200,000 300,000

300,000

1 1 300,000 + 1 N 10 r (1 + r ) (1 + r )

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Setting the NPV = 0 and solving for N gives

300,000 500,000 10 (1+ r ) log 200,000 N= log(1 + r )

1.5 log 2.5 10 1.1 =A log(1.1) = 6.85 years

d. Timeline: 0 1 2 3 6 7 16

200,000 200,000 200,000

NPV = =

200,000 300,000

300,000

200,000 1 1 300,000 1 + 1 1 6 6 10 r r (1 + r ) (1 + r ) (1 + r ) 200,000 1 1 0.14 (1.14)6 1 1 300,000 + 1 6 10 (1.14) 0.14 (1.14)

= $64.816

e. Since the IRR still has not changed it is still 12.66%, so if the estimate is too high by 1.34%, the decision will change. f. Setting the NPV = 0 and solving for N gives:
NPV = 1 300,000 1 + 1 6 N (1.14) .14 (1.14) 1 = 777,733.5 + 976,256.9 1 =0 N (1.14) = 198,523.4 = 200,000 1 1 .14 (1.14)6 =0

976,256.9 = 0 (1.14)N = 4.9176 (1.14) N N log(1.14) = log(4.9176) 0.131N = 1.5928 N = 12.16 years

Evaluate: When your cost of capital is greater than your IRR your project will produce a negative NPV, and according to the NPV rule you should not accept this project if there is an alternative project with a higher or positive NPV. In this case, a lower cost of capital produced a higher NPV and also happens to be less of a time commitment because this project takes half the time of the second project.

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5. a.

b. The IRR is the point at which the line crosses the x-axis. In this case, it falls very close to 13%. Using Excel, the IRR is 12.72%. c. Yes, because the NPV is positive at the discount rate of 12%. d. The discount rate could be off by 0.72% before the investment decision would change. 6. 5000/500 = 10 months. You will recover your expenditure for the sign in 10 months. 7. The IRR is 39.45%. The IRR rule agrees with the NPV rule. 8. Plan: We can compute the IRR by first computing the NPV and find the rate that sets that NPV equal to zero. In order to determine how many IRRs will set NPV equal to zero we can plot NPV as a function of the discount rate. Execute: Timeline: 0 1 2 3

10

IRR is the r that solves

NPV = 0 8 1 = 10 1 r (1 + r )3

To determine how many solutions this equation has, plot the NPV as a function of r.

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From the plot there is one IRR of 60.74%. Since the IRR is much greater than the discount rate, the IRR rule says write the book. Since this is a negative NPV project (from 6.2(a)), the IRR gives the wrong answer. Evaluate: In this case there is only one IRR (the intercept on the x-axis) and the IRR is greater than the discount rate. According to the IRR rule, Bill should accept the project, yet because the NPV is negative, the NPV rule states that Bill should not accept the project. Although the two rules are conflicting, the NPV rule tends to be more reliable. 9. Plan: We can compute the IRR by first computing the NPV and finding the rate that sets that NPV equal to zero. In order to determine how many IRRs will set NPV equal to zero, we can plot NPV as a function of the discount rate. Execute: Timeline: 0 1 2 3 4 5 6

10

5(1 0.3) 5(1.03)2

From 6.2(b) the NPV of these cash flows is

8 1 1 5 NPV = 10 1 + 3 r (1 + r ) (1 + r )3 r + 0.3

Plotting the NPV as a function of the discount rate gives

The plot shows that there are 2 IRRs 7.165% and 41.568%. The IRR does give an answer in this case, so it does not work.

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Evaluate: In this case there are two IRRs (the intercepts on the x-axis) and the IRR does not provide an answer, so we cannot use the IRR rule and therefore the IRR rule does not work in this case. 10. Plan: Setting the NPV to zero, we can solve for the IRR and we can then compute the NPV of the project using Eq. (7.2). The cash flows are an immediate $50,000 cash flow followed by an annuity of $4,400 per year and a discount rate of 15%. Execute: The timeline of this investment opportunity is: 0 1 2 12

50,000

4400

4400

4400

Computing the NPV of the cash flow stream

NPV = 50,000 4400 1 1 r (1 + r )12

To compute the IRR, we set the NPV equal to zero and solve for r. Using the annuity spreadsheet gives N 12 I 0.8484% PV 50,000 PMT 4400 FV 0

The monthly IRR is 0.8484, so since

(1.008484)12 = 1.106696

0.8484% monthly corresponds to an EAR of 10.67%. Smiths cost of capital is 15%, so according to the IRR rule, she should turn down this opportunity. Lets see what the NPV rule says. If you invest at an EAR of 15%, then after one month you will have
(1.15)1/ 2 = 1.011715,

so the monthly discount rate is 1.1715%. Computing the NPV using this discount rate gives
NPV = 50,000 4400 1 1 12 0.011715 (1.011715)

= $1010.06.

Which is positive, so the correct decision is to accept the deal. Smith can also be relatively confident in this decision. Based on the difference between the IRR and the cost of capital, her cost of capital would have to be 15 10.67 = 4.33% lower to reverse the decision.

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Evaluate: The internal rate of return (IRR) investment rule is based on the concept that if the return on the investment opportunity you are considering is greater than the return on other alternatives in the market with the equivalent risk and maturity, you should undertake the investment opportunity. In this case, the IRR is less than the discount rate so according to the IRR rule, she should turn down this opportunity. The NPV rule states that when making an investment decision, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today. In this case, the NPV is positive, so the correct decision is to accept the deal. 11. Plan: We can compute the NPV of the project using Eq. (7.2). Setting the NPV to zero, we can then solve for the IRR and then analyze the results according to the IRR rule. Execute: a. Timeline: 0 1 2 10 11 12

1 0.1 1 0.1

1 0.1

0.1

0.1

The PV of the profits is

1 1 PVprofits = 1 r (1 + r )10

The PV of the support costs is

PVsupport = 0.1 r NPV = 5 + PVprofits + PVsupport 1 1 = 5 + 1 r (1 + r )10
0.1 r

r = 5.438761% then NPV = $721,162 r = 2.745784% then NPV = 0 r = 10.879183% then NPV = 0 b. From the answer to part (a) there are 2 IRRs: 2.745784% and 10.879183%. c. The IRR rule says nothing in this case because there are 2 IRRs. Evaluate: The internal rate of return (IRR) investment rule is based on the concept that if the return on the investment opportunity you are considering is greater than the return on other alternatives in the market with the equivalent risk and maturity you should undertake the investment opportunity. In this case, there are two IRRs and therefore the IRR rule is not useful. The NPV rule states that when making an investment decision, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today. In this case, the NPV is positive only when the cost of capital is at 6% and therefore they should accept the project at the cost of capital of 6% only.

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12. Plan: We can compute the IRR by first computing the NPV and finding the rate that sets that NPV equal to zero. In order to determine how many IRRs will set NPV equal to zero we can plot NPV as a function of the discount rate. Execute: The timeline of this investment opportunity is: 0 1 2 10 11 12

120

20

20

20

Computing the NPV of the cash flow stream:

NPV = 120 + 20 1 1 r (1 + r )10 2 10 r (1 + r )

You can verify that r = 0.02924 or 0.08723 gives an NPV of zero. There are two IRRs, so you cannot apply the IRR rule. Lets see what the NPV rule says. Using the cost of capital of 8% gives
NPV = 120 + 20 1 1 r (1 + r )10 2 10 r (1 + r )

= 2.621791

So the investment has a positive NPV of $2,621,791. In this case the NPV as a function of the discount rate is n-shaped.

If the opportunity cost of capital is between 2.93% and 8.72%, the investment should be undertaken. Evaluate: The internal rate of return (IRR) investment rule is based on the concept that if the return on the investment opportunity you are considering is greater than the return on other alternatives in the market with the equivalent risk and maturity you should undertake the investment opportunity. In this case, there are two IRRs and therefore the IRR rule is not useful. The NPV rule states that when making an investment decision, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today. In this case, the NPV is positive and the investment should be undertaken if the opportunity cost of capital is between 2.93% and 8.72%.

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13. Plan: Compute various IRR calculations for the proposed project. Execute: The timeline of the investment opportunity is: 0 1 2 3 4

4.55

3.5

3.5

3.5

a. Looking at the NPV profile below, this project has 2 IRRs.

b. To use the MIRR approach, calculate the PV of the cleanup costs and add this value to the initial startup costs.
PV(cleanup costs) = 6 (1.10) 4 = $4.098

The new timeline of cash flows associated with this investment is now: 0 1 2 3 4

4.55 4.098 = 8.648

3.5

3.5

3.5

MIRR of these cash flows is 10.37%. Evaluate: c. MIRR is greater than the cost of capital, so the investment should be taken.

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14. Plan: Compute the NPV of the project. Execute: The timeline of the investment opportunity is: Timeline: 0 1 2 3 4 5

Investment

To have an NPV greater than zero, the initial investment must be less than the PV of the 5-year annuity of $1 million per year.
NPV = 0 < Initial Investment + 1 1 1 5 0.12 (1 + 0.12)

Initial investment > 3.6 million Evaluate: The most you could pay for the project and achieve the 12% annual return is $3.6 million. *15. Plan: Compute the modified IRR of the project. Execute: The timeline of the investment opportunity is: 0 1 2 3 8 9 10

5.4

1.1

1.1

1.1

1.1

1.1

1.1 Shutdown costs

In order to earn the 15% cost of capital, the NPV must be positive. To determine the maximum shutdown costs allowable to still have a positive NPV:
NPV = 0 < 5.4 +
Shutdown costs > $0.488

1.1 1 1 0.15 (1 + 0.15)10

Shutdown costs + (1.15)10

Evaluate: Shutdown costs cannot exceed $488,000. *16. Plan: We can compute IRR of this investment by first computing the NPV by subtracting the stabilization costs of the project from the operating profit. We can than find the IRR of the investment by plotting the NPV as a function of the discount rate.

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Execute: Timeline: 0 1 2 3 20 21 22

250

20

20

20
PVoperating profits =

20

20 1 1 r (1 + r ) 20

In year 20, the PV of the stabilization costs is

PV20 = 5 r

So the PV today is
PVstabilization costs = 1 5 (1 + r )20 r 20 1 1 5 1 r 20 r (1 + r ) (1 + r )20

NPV = 250 +

Plotting this out gives

So no IRR exists. Evaluate: In order for a project to be profitable, IRR has to be greater than the discount rate. In this case, since there is no IRR, NPV must the less than zero = 0.

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17. Plan: In order to implement the payback rule, we need to know whether the sum of the inflows from the project will exceed the initial investment before the end. We can compute the NPV of the project using Eq. (7.2). Execute: Timeline: 0 1 2 3 4 5 6

10

It will take 5 years to pay back the initial investment, so the payback period is 5 years. You will not make the movie.
NPV = 10 + 5 2 1 1 + 1 2 (1 + r ) r (1 + r )4 (1 + r )2 5 2 1 = 10 + + 1 2 2 (1.1) 0.1(1.1) (1.1)4 = $628,322

So the NPV agrees with the payback rule in this case. Evaluate: While simple to compute, the payback rule requires us to use an arbitrary cutoff period in summing the cash flows. Further, the payback rule does not discount future cash flows. Instead it simply sums the cash flows and compares them to a cash outflow in the present. In this case, you will not make the movie because your cutoff point is 2 years and it will take 5 years to pay back the initial investment. The NPV of this project came back as negative, so this also agrees with the payback rule and the movie should therefore not be made. 18. Plan: We can compute the IRR by rearranging Eq. (7.2) so that NPV equals zero and solving for r. Once we compute r, we can compute the NPV of both projects using Eq. (7.2). 0 1 2 3 4

100 50

25 20

20 40

20 50

15 60

a. NPVA = 50 +

25 20 20 15 + + + 2 3 1 + r (1 + r ) (1 + r ) (1 + r )4 20 40 50 60 + + + 2 3 1 + r (1 + r ) (1 + r ) (1 + r )4

IRR (A) = 24% NPVB = 100 + IRR (B) = 21%

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b. NPVA = 50 +
= 21.57

25 20 20 15 + + + 1 + 0.05 (1 + 0.05)2 (1 + 0.05)3 (1 + 0.05)4 20 40 50 60 + + + 2 3 1 + 0.05 (1 + 0.05) (1 + 0.05) (1 + 0.05)4

NPVB = 100 + = 47.88

Evaluate: The IRR and NPV rank differently due to the difference in the initial investment. Investment A earns a higher rate of return on a smaller investment. 19. Plan: Compute the timeline and the NPV and IRR for each project. Decide which one to accept. Execute: a. Timeline: 0 1 2 3

A B

10 10

2 1.5

2 2 1.5(1.02) 1.5(1.02)2
NPVA = 2 10 r

Setting NPVA = 0 and solving for r IRRA = 20% 1.5 10 NPVB = r 0.02 Setting NPVB = 0 and solving for r
1.5 = 10 r 0.02 = 0.15 r = 17%. r 0.02

So,
IRR B = 17%.

Based on the IRR you always pick Project A. b. Substituting r = 0.07 into the NPV formulas derived in part (a) gives NPVA = $18.5714 million NPVB = $20 million So the NPV says take B.

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c. Here is a plot of NPV of both projects as a function of the discount rate. The NPV rule selects A (and so agrees with the IRR rule) for all discount rates to the right of the point where the curves cross.

NPVA = NPVB 2 1.5 = r r 0.02 r r 0.02 = 2 1.5 1.5r = 2r 0.04 0.5r = 0.04 r = 0.08

Evaluate: Based on the IRR you always pick Project A. Based on the NPV take B. So the IRR rule will give the correct answer for discount rates greater than 8%. 20. Plan: Compute the NPV and the IRR of each project. Execute: The timeline of the investment opportunity is: 0 1 2 3 4

100 100

25 50

30 40

40 30

50 20

a. NPVA = 100 +
NPVB = 100 +

25 30 40 50 + + + = 9.06 2 3 1 + 0.11 (1 + 0.11) (1 + 0.11) (1 + 0.11)4 50 40 30 20 + + + = 12.62 2 3 1 + 0.11 (1 + 0.11) (1 + 0.11) (1 + 0.11)4

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b. Solving for the discount rate that results in zero NPV IRR(A) = 14.7% IRR(B) = 17.8% c. This can be solved two ways. One is to calculate the IRR of the difference in cash flows between the two projects. The other is to create NPV profiles of both investments and determine the cost of capital at which the NPVs of both projects are the same. 0 1 2 3 4

100 100 0

25 50 25
NPV = 0 =

30 40 10

40 30 10

50 20 30

10 30 25 10 + + + 2 3 1 + r (1 + r ) (1 + r ) (1 + r )4 IRR = 5.567%

NPV Profiles of Investments A and B:

The profiles cross at a cost of capital of 5.567%. Evaluate: d. You should invest in B, as it has a higher NPV.

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21. Plan: Compute the cost of ownership of the asset as well as the cost of leasing the asset. Select the option with the lowest cost. Execute: The timeline of the investment opportunity is: 0 1 2 3 4 5

Ownership Leasing:

40

2 10
NPVownership = 40 +

2 10

2 10

2 10

2 10

2 1 1 0.07 (1 + 0.07)5

NPVleasing

= 48.2 10 1 = 1 5 0.07 (1 + 0.07) = 41

Evaluate: The cost of leasing is less, so the firm should lease the equipment. 22. Plan: Compute the NPV and the Equivalent Annual Annuity (EAA) of each bus. Choose the bus with the lowest costs. Execute: The timeline of the investment opportunity is: 0 Old Reliable Short and Sweet 200 100 1 4 2 2 4 2 3 4 2 4 4 2 5 4 6 4 7 4

NPVOld Reliable = 200 +

1 4 1 7 0.11 (1 + 0.11)

= 218.85 EAA Old Reliable 1 218.85 = 1 7 0.11 (1 + 0.11) EAA Old Reliable = 46.44 NPVShort and Sweet = 100 + 1 2 1 4 0.11 (1 + 0.11)

= 106.20 EAA Short and Sweet 106.20 = 0.11 EAAShort and Sweet = 34.23

1 1 4 (1 + 0.11)

Evaluate: The annual cost of the Short and Sweet bus is less, so they should buy this bus.

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23. Plan: Compute the NPV and the Equivalent Annual Annuity (EAA) of this investment opportunity. Determine the lowest value enhancing bid. Execute: The timeline of the investment opportunity is: 0 Timeline: 15 1 2
NPV = 15 +

2 2

3 2

1 2 1 3 0.10 (1 + 0.10)

= 19.97 EAA 1 19.97 = 1 3 0.10 (1 + 0.10) EAA = 8.032

Evaluate: Hassle-free could bid as little as $8,032 per year and increase its value. 24. Plan: Compute the NPVs of the alternatives. Select the alternative with the highest NPV. Execute: a. NPV A B C $2 million $1 million $1.5 million Use of Facility NPV/Use of Facility 100% 60% 40% 2 1.67 3.75

b. They should invest in B and C. Together, these result in an NPV of $2.5 million, which is greater than the $2 million NPV earned by A alone. 25. Plan: Compute the NPV and Profitability Index of each proposed investment. Select the best combination of investments. Execute: Project Parkside Acres Real Property Estates Lost Lake Properties Overlook NPV 91,765 120,523 40,392 80,131 Profitability Index 0.18 0.15 0.06 0.53

Evaluate: The PI implies that Overlook and Parkside Acres should be selected. Note that $150,000 of the capital budget is unused. The alternative investment opportunities that meet the resource constraint are: (i) Real Property Estates alone, (ii) Lost Lake and Overlook, or (iii) Parkside and Overlook. All of these alternatives generate lower NPVs, so in this case the PI rule gives the correct answer, although as the text explains, this need not always be the case when the complete budget is not used by taking the projects in order.

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26. Plan: Compute the NPV and Profitability Index of each proposed investment. Select the best combination of investments. Execute: Project I II III IV V 1.01 1.27 1.47 1.25 2.01 PI 5.1 6.3 5.5 8.3 6.0 NPV/Headcount

Evaluate: a. The PI rule selects Projects V, III, II. These are also the optimal projects to undertake (as the budget is used up fully taking the projects in order). b. The PI rule selects IV and II alone, because the project with the next highest PI (that is NPV/Headcount), V, cannot be undertaken without violating the resource constraint. However, this choice of projects does not maximize NPV. Orchid should also take on III and I. This solution is better than taking V and I (which is also affordable), and shows that it may be optimal to skip some projects in the PI ranking if they will not fit within the budget (and there is unused budget remaining).