7-1
Chapter 7
Answers to Review Problems
Finance For Executives – 4th Edition
1. Investment criteria.
a.
Impact on earnings per share (EPS) is an accounting measure of performance. Its main drawbacks
are that it ignores capital investment required for the project, penalizes projects whose earnings
are not immediately realized, and is subject to accounting manipulation. Yet there is a strong
b.
Global Chemicals uses all of these measures, no doubt, because the various managers (and also
board members for large project decisions) want them. Some of those taking part in the
investment decision process are more comfortable with certain measures than others. If the
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2. Relationship between investment criteria.
The information given tells:
• Nothing about the discounted payback period
3. Net present value and payback period.
If the payback period is less than the economic life of the project, its net present value can be
either positive or negative. This is because the relevant cash flows in the computation of the
payback period are actual cash flows while those in the computation of the net present value are
discounted cash flows. The only certain case is the trivial case when the cost of capital of the
project is zero. In that case, the project’s net present value is, by definition, equal to zero at its
payback period. Since it lasts longer, its net present value is positive.
4. The internal rate of return of mutually exclusive projects.
a.
The intersection of Project A and Project B’s NPV lines represents the discount rate which
produces the same NPV for the two projects. Assuming the risk of each project is the same, and
the firm’s cost of capital is the discount rate at the intersection point, one should be indifferent
between the two projects.
d.
The choice depends on the cost of capital. When the cost of capital is lower than the break-even
rate (the point where the project NPV lines intersect), Project A is better, and Project B is better
when the cost of capital is higher than the break-even rate. Note that the choice between the two
projects cannot be made by comparing their internal rates of return because those rates have no
particular economic significance.
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5. The case of multiple internal rate of return.
This project shows cash flows with alternating negative and positive signs. Though the project is
perhaps unrealistically simple, it is designed to illustrate a weakness of the internal rate of return
approach.
a. and b.
Using a spreadsheet
A B C D E F G
10 1 2
2 Cash flows -$200 $600 -$400
3
4 Cost of capital 0% 25% 50% 100%
5
There are two internal rates of return (IRR)—at 0 percent and 100 percent discount rates. Rates
between 0 percent and 100 percent produce positive net present values (NPV). Rates below 0
c.
The project should be accepted if its net present value is positive. This will be the case if the cost
of capital is above 0 percent and less than 100 percent.
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6. The net present value rule versus the internal rate of return.
Note that this is an “either or” type of problem and that the two projects are of different scale.
a.
Using a spreadsheet
A B C D
10 1 2
2PROJECT A
3 Cash flows -$12,000 $7,900 $6,850
4
12
13 Internal rate of return
14
15 Internal rate of return 15.3%
16
17 The formula in cell B15 is: =IRR(B3:D3,.1), where .1 is a guess value for IRR.
18
19 PROJECT B
20 Cash flows -$2,400 $2,500 $950
21
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b.
Project B is a better choice based on internal rate of return, while project A is a better choice
based on net present value.
d.
The net present value rule is the least ambiguous assuming that the cost of capital rate has been
estimated correctly and that the firm does not have any capital constraints.
e.
The internal rate of return of the incremental cash flows (Project A’s minus Project B’s cash
7. The internal rate of return rule and the net present value rule.
a and b
Using a spreadsheet
A B C D
10 1 2
2 PROJECT A
3 Cash flows -$150,000 $120,000 $80,000
4
5 Cost of capital 12%
14
15 Internal rate of return 23.3%
16
17 The formula in cell B15 is: =IRR(B3:D3,.1), where .1 is a guess value for IRR.
18
19 PROJECT B
20 Cash flows -$300,000 $200,000 $180,000
21
31
32 The formula in cell B30 is: =IRR(B20:D20,.1), where .1 is a guess value for IRR.
33
34 PROJECT C
35 Cash flows -$150,000 $110,000 $90,000
36
37 Net present value
38
39 Net present value $19,962
40
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c.
The three projects should be accepted since their net present value is positive and their internal
rate of return is higher than the cost of capital (12 percent).
8. The net present value rule versus the profitability index rule.
Note that this is an “either or” type of problem and that the two projects are of different scale.
a.
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A B C D E
1 0 1 2 3
2 PROJECT A
3 Cash flows -$16,000 $10,500 $9,100 $3,000
4
5 Cost of capital 10%
6
16
17 The formula in cell B15 is: =NPV(B5,C3:E3)/-B3.
18
19 PROJECT B
20 Cash flows -$3,200 $3,300 $1,260 $600
21
22 Net present value
23
24 Net present value $1,292
b.
Project B is a better choice based on the profitability index rule, while project A is a better choice
based on net present value.
9. The average accounting return
Using a spreadsheet
A B C D E F G
1 1 2 3 4 5
2 Initial cash outlay $2,000,000
3
7
8 The formula in cell B4 is: +SLN(B2,0,5), where 0 is the salvage value of the machine at the end of year 5 and 5 is the life of the machine.
9 The formula in cell C5 is: =B5-$B$4. Then copy formula in cell C5 to cells D5, E5, F5, and G5.
10 The formula in cell B6 is: =average(B5:G5).
11
12 Earnings after-tax – Year 1 $200,000
13 Growth rate after Year 1 10%
14 Earnings after-tax $200,000 $220,000 $242,000 $266,200 $292,820
According to the average accounting return rule, the machine should be bought since the average
accounting return is higher than the target return (24.4 percent versus 20 percent). However, you
should question the approach on the basis of the following considerations:
1. The approach ignores the time value of money. To account for it, the approach should
have used cash flows instead of earnings and discount those cash flows to present.
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10. 10. Investment criteria.
a.
Using a spreadsheet
A B C D E F G
10 1 2 3 4 5
2 Cash flows -$18,000 $5,200 $5,200 $5,200 $5,200 $7,200
3
4 Payback period
5
6 Accumulated cash inflows $5,200 $10,400 $15,600 $20,800 $28,000
16
17 Discounted cash inflows $4,727 $4,298 $3,907 $3,552 $4,471
18 Accumulated discounted cash flows $4,727 $9,025 $12,932 $16,483 $20,954
19
20 Discounted payback period – – – – 4.34
28 Net present value $2,954
29
30 The formula in cell B28 is: =B2 + NPV(B15,C2:G2).
31
32 Internal rate of return
33
34 Internal rate of return 16.0%
35
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b.
Considering the above measures, the project appears to be satisfactory since the net present value
is positive, the profitability index is greater than 1.0, the internal rate of return is above 10 percent
(assuming that 10 percent is the cost of capital), and the payback periods indicate the investment
outlay will be recovered during the life of the project.