Chapter 12: The Capital Budgeting Decision
12-21
3 25,000 .751 18,775
12–18. (Continued)
b. Internal Rate of Return
We will average the inflows to arrive at an assumed annuity.
$15,000
We divide the investment by the assumed annuity value.
IFA
$45,000 3 PV
$15,000 =
Year Cash Flow × 20% PVIF Present Value
1 $15,000 .833 $12,495
2 20,000 .694 13,880
Chapter 12: The Capital Budgeting Decision
Since 20% is not high enough, we try the next highest rate
at 25%.
Year Cash Flow × 25% PVIF Present Value
1 $15,000 .800 $12,000
12–18. (Continued)
The correct answer must fall between 20% and 25%. We
interpolate.
$47,680 ………. PV @ 20% $47,680 ………… PV @ 20%
Chapter 12: The Capital Budgeting Decision
Project X (Videotapes
of the Weather Report)
($10,000 Investment)
Project Y (Slow-Motion
Replays of Commercials)
($30,000 investment)
Year
Year
Cash Flow
1 ……………………
1 …………………………...
$15,000
2 ……………………
2 …………………………...
8,000
3 ……………………
3 …………………………...
9,000
4 ……………………
4 …………………………...
11,000
12–19. Solution:
Norton Corporation
NPV for Project X
Year Cash Flow × PVIF at 10% Present Value
1 $5,000 .909 $ 4,545
Present value of inflows $12,486
Chapter 12: The Capital Budgeting Decision
12-24
NPV for Project Y
Year Cash Flow × PVIF at 10% Present Value
1 $15,000 .909 $ 13,635
Present value of inflows
Profitability index (Y) Present value of outflows
$34,515 1.1505
$30,000
=
==
20. Reinvestment rate assumption in capital budgeting (LO4) Turner Video will invest
$48,500 in a project. The firm’s cost of capital is 9 percent. The investment will provide
the following inflows.
Year
Inflow
1 …………….
$10,000
2 …………….
12,000
3 …………….
16,000
4 …………….
20,000
5 …………….
24,000
The internal rate of return is 14 percent.
Chapter 12: The Capital Budgeting Decision
12-25
a. If the reinvestment assumption of the net present value method is used, what will be
the total value of the inflows after five years? (Assume the inflows come at the end of
each year.)
b. If the reinvestment assumption of the internal rate of return method is used, what will
be the total value of the inflows after five years?
c. Generally is one investment assumption likely to be better than another?
12–20. Solution:
Turner Video
a. Reinvestment assumption of NPV
No. of Future
Year Inflows Rate Periods Value Factor Value
1 $10,000 9% 4 1.412 $14,120
2 12,000 9% 3 1.295 15,540
12–20. (Continued)
b. Reinvestment assumption of IRR
No. of Future
Year Inflows Rate Periods Value Factor Value
1 $10,000 14% 4 1.689 $ 16,890
2 12,000 14% 3 1.482 17,784
Chapter 12: The Capital Budgeting Decision
12-26
c. No. However, for investments with a very high IRR, it may
21. Modified internal rate of return (LO4) The Caffeine Coffee Company uses the modified
internal rate of return. The firm has a cost of capital of 12 percent. The project being
analyzed is as follows ($27,000 investment):
Year
Cash Flow
1 ………..
$15,000
2 ………..
12,000
3 ………..
9,000
a. What is the modified internal rate of return? An approximation from Appendix B is
adequate. (You do not need to interpolate.)
b. Assume the traditional internal rate of return on the investment is 17.5 percent.
Explain why your answer in part a would be lower.
12–21. Solution:
Caffeine Coffee Company
Terminal Value (end of year 3)
a. FV Factor
Period of (12%) Future
Growth (Appendix A) Value
Year 1 $15,000 2 1.254 $18,810
To determine the modified internal rate of return, calculate
the yield on the investment.
Chapter 12: The Capital Budgeting Decision
12-27
IF
PV
PV (Appendix B)
FV
$27,000
= .655
41,250
==
=
15 percent (.658).
12–21. (Continued)
b. The answer is lower than 17 percent under the Modified IRR
22. Capital rationing and mutually exclusive investments (LO4) The Suboptimal Glass
Company uses a process of capital rationing in its decision making. The firm’s cost of
capital is 13 percent. It will only invest only $60,000 this year. It has determined the
internal rate of return for each of the following projects.
Project
Project Size
Internal Rate of
Return
A ………………..
$10,000
15%
B …………………
30,000
14
C …………………
25,000
16.5
D ………………..
10,000
17
E …………………
10,000
23
F …………………
20,000
11
G ………………..
15,000
16
a. Pick out the projects that the firm should accept.
b. If Projects D and E are mutually exclusive, how would that affect your overall
answer? That is, which projects would you accept in spending the $60,000?
Chapter 12: The Capital Budgeting Decision
12-28
12–22. Solution:
Suboptimal Glass Company
You should rank the investments in terms of IRR.
Project IRR Project Size Total Budget
E 23% $10,000 $ 10,000
D 17 10,000 20,000
a. Because of capital rationing, only $60,000 worth of projects
b. If Projects D and E are mutually exclusive, you would select
23. Net present value profile (LO4) Keller Construction is considering two new investments.
Project E calls for the purchase of earthmoving equipment. Project H represents an
investment in a hydraulic lift. Keller wishes to use a net present value profile in comparing
the projects. The investment and cash flow patterns are as follows:
Chapter 12: The Capital Budgeting Decision
12-29
Project E
($20,000 Investment)
Project H
($20,000 investment)
Year
Cash Flow
Year
Cash Flow
1 …………………….
$ 5,000
1 …………………………..
$16,000
2 …………………….
6,000
2 …………………………..
5,000
3 …………………….
7.000
3 …………………………..
4,000
4 …………………….
10,000
a. Determine the net present value of the projects based on a zero discount rate.
b. Determine the net present value of the projects based on a 9 percent discount rate.
c. The internal rate of return on Project E is 13.25 percent, and the internal rate of return
on Project H is 16.30 percent. Graph a net present value profile for the two
investments similar to Figure 12-3. (Use a scale up to $8,000 on the vertical axis, with
$2,000 increments. Use a scale up to 20 percent on the horizontal axis, with
5 percent increments.)
d. If the two projects are not mutually exclusive, what would your acceptance or
rejection decision be if the cost of capital (discount rate) is 8 percent? (Use the net
present value profile for your decision; no actual numbers are necessary.)
e. If the two projects are mutually exclusive (the selection of one precludes the selection
of the other), what would be your decision if the cost of capital is (1) 6 percent,
(2) 13 percent, (3) 18 percent? Once again, use the net present value profile for your
answer.
12–23. Solution:
Keller Construction Company
a. Zero discount rate
Project E
Inflows Outflow
Project H
Inflows Outflow
Chapter 12: The Capital Budgeting Decision
12-30
Project E
Year Cash Flow PVIF at 9% Present Value
1 $ 5,000 .917 $ 4,585
2 6,000 .842 5,052
12-23. (Continued)
Project H
Year Cash Flow PVIF at 9% Present Value
1 $16,000 .917 $14,672
2 5,000 .842 4,210