You are considering making a movie.

The movie is expected to cost $10 million upfront and take a year to make.
After that, it is expected to make $5 million in the year it is released and $2 million for the following four years.
What is the payback period of this investment? If your equire a payback period of two years, will you make the
movie? Does the movie have positive NPV if the cost of capital is 10%?
Year

Cash Flow
0
1
2
3
4
5

-$10,000,000
$5,000,000
$2,000,000
$2,000,000
$2,000,000
$2,000,000

Cumulative Cash Flow

-$10,000,000
-$5,000,000
-$3,000,000
-$1,000,000
$1,000,000
$3,000,000

Since cumulative cash turned positive in year 4 so the payback period would be between 3 to 4
years.
Payback Period = 3+1000000/2000000 = 3.5 Year
Since the payback period is 3.5 years and the required payback period is 2 years we will not
make the movie.
Year

Cash Flow
0
1
2
3
4
5

PV factor @ 10%
-$10,000,000
$5,000,000
$2,000,000
$2,000,000
$2,000,000
$2,000,000

1
0.90909
0.82645
0.75131
0.68301
0.62092
NPV

Present Value
$10,000,000
$4,545,455
$1,652,893
$1,502,630
$1,366,027
$1,241,843
$308,846

Yes the movie has a positive NPV of $308,846

7-21.
You are deciding between two mutually exclusive investment opportunities. Both require the same
initial investment of $10 million. Investment A will generate $2 million per year (starting at the end of the
first year) in perpetuity. Investment B will generate $1.5 million at the end of the first year and its
revenues will grow at 2% per year for every year after that.
a.

hWinvcestmagrIR?

b.

hWinvcestmagrNPVwopfclits7%?

c.

nthIiscaoe,rwfvlu pdnickhgetRrIvoaswnhicetmbpoyru?

Solution to Question 2.7:

a.

Timeline:

A
B

NPVA

10
10

2
1.5

2
1.5(1.02)

2
1.5(1.02)2

2
10
r

Setting NPVA = 0 and solving for r

IRRA = 20%

NPVB

1.5
10
r 0.02

Setting NPVB = 0 and solving for r

1.5
10 r 0.02 0.15 r 17%. So, IRRB 17%
r 0.02
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.

c.

Here is a plot of the 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
r
r
2
1.5r
0.5r
r

1.5
r 0.02
r 0.02

1.5
2r 0.04
0.04
0.08

So the IRR rule will give the correct answer for discount rates greater than 8%

Forecasting earnings
Pisa Pizza, a seller of frozen pizza, is considering introducing a healthier
version of its pizza that will be low in cholesterol and contain no trans fats.
The firm expects that sales of the new pizza will be $20 million per year.
While many of these sales will be to new customers, Pisa Pizza estimates
that 40% will come from customers who switch to the new, healthier pizza
instead of buying the original version.
a. Assume customers will spend the same amount on either version. What level of
incremental
sales is associated with introducing the new pizza?
Sales of new pizza lost sales of original = 20 0.40*20 = $12 million
b. Suppose that 50% of the customers who will switch from Pisa Pizzas original
pizza to its
healthier pizza will switch to another brand if Pisa Pizza does not introduce a
healthier
pizza. What level of incremental sales is associated with introducing the new pizza
in this
case?
Sales of new pizza lost sales of original pizza from customers who
would not have switched
brands = 20 0.50*0.40*20 = $16 million