216 Gitman/Zutter Principles of Managerial Finance, Brief, Seventh Edition
P11-22 Personal Finance: Impact of inflation on investments
LG 2; Easy
a. c.
Year
Investment
Cash
Flows
Current
NPV (a)
Higher
Inflation
NPV (b)
Lower
Inflation
NPV (c)
0
1
(40,000)
12,000
(40,000)
11,267.61
(40,000)
11,111.11
(40,000)
11,428.57
d. If inflation’s primary effect is to raise the discount rate, then the NPV will fall. Of course, for many
investment projects, inflation may affect not only the discount rate but also the cash flows, and in that
case, the relationship between changes in inflation and asset valuation is less clear than it is here.
P11-23 Simulation
LG 2; Intermediate
a. Ogden Corporation could use a computer simulation to generate the respective profitability
distributions through the generation of random numbers. By tying various cash flow assumptions together
b. The advantages to computer simulations include the decision maker’s ability to view a continuum of
P11-24 Risk-adjusted discount rates—Basic
LG 4; Intermediate
a. Project E
N 4, I 15%, PMT $6,000
Project F
Project G
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217 Gitman/Zutter Principles of Managerial Finance, Brief, Seventh Edition
CF0 −$19,000, CF1 $4,000, CF2 $6,000, CF3 $8,000, C44 $12,000
b. RADRE 0.10 [1.80 (0.15 0.10)] 0.19
c. Project E
N 4, I 19%, PMT $6,000
Project F
Same as in part a, $1,673.05
Project G
CF0 −$19,000, CF1 $4,000, CF2 $6,000, CF3 $8,000, CF4 $12,000
Rank Project
1 G
P11-25 Risk-adjusted discount rates—Tabular
LG 4; Intermediate
a. Project A
N 5, I 8%, PMT $7,000
Project B
N 5, I 14%, PMT $10,000
Project A, with the higher NPV, should be chosen.
P11-26 Personal Finance: Mutually exclusive investment and risk
LG 4; Intermediate
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Chapter 11: Capital Budgeting Cash Flows and Risk Refinements 218
a. N 6, I 8.5%, PMT $3,000
b. N 6, I 10.5%, PMT $3,800
P11-27 Risk-adjusted rates of return using CAPM
LG 4; Challenge
a. rX 7% 1.2(12% 7%) 7% 6% 13%
NPV calculation for X:
Solve for PV 89,234.14
NPV calculation for Y:
Solve for NPV $18,805.82
b. The RADR approach prefers Project Y over Project X. The RADR approach combines the risk
P11-28 Risk classes and RADR
LG 4; Basic
a. Project X
CF0 −$180,000, CF1 $80,000, CF2 $70,000, CF3 $60,000,
Project Y
CF0 −$235,000, CF1 $50,000, CF2 $60,000,
Solve for NPV $2,663.99
Project Z
CF0 −$310,000, CF1 $90,000, CF2 $90,000, CF3 $90,000,
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219 Gitman/Zutter Principles of Managerial Finance, Brief, Seventh Edition
Solve for NPV −$8,306.04
P11-29 Unequal lives—ANPV approach
LG 5; Intermediate
a. Machine A
CF0 −$92,000, CF1 $12,000, CF2 $12,000, CF3 $12,000,
Machine B
CF0 −$65,000, CF1 $10,000, CF2 $20,000, CF3 $30,000, CF4 $40,000
Machine C
CF0 −$100,500, CF1 $30,000, CF2 $30,000,
Rank Machine
1 C
(Note that Machine A is not acceptable and could be rejected without any additional analysis.)
b. Machine A
N 6, I 12%, PV $42,663.11
Machine B
N 4, I 12%, PV $6,646.58
Machine C
N 5, I 12%, PV $7,643.29
Rank Machine
1 B
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Chapter 11: Capital Budgeting Cash Flows and Risk Refinements 220
P11-30 Unequal lives—ANPV approach
LG 5; Intermediate
a. Sell
CF0 −$200,000, CF1 $200,000, CF2 $250,000
License
CF0 −$200,000, CF1 $250,000, CF2 $100,000
Manufacture
CF0 −$450,000, CF1 $200,000, CF2 $250,000, CF3 $200,000,
Rank Alternative
1 Manufacture
b. Sell
N 2, I 12%, PV $
Manufacture
Rank Alternative
1 Sell
2 Manufacture
3 License
c. Comparing the NPVs of projects with unequal lives gives an advantage to those projects that generate
P11-31 NPV and ANPV decisions
LG 5; Challenge
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221 Gitman/Zutter Principles of Managerial Finance, Brief, Seventh Edition
a. – b. Unequal-Life Decisions
Annualized Net Present Value (ANPV)
Samsung Sony
Cost
$(2,350)
$(2,700)
a. CF0 −$2,350, CF1 $900, CF2 $900, CF3 $900 + $400 $1,300
b. N 3, I 9%, PV $237.04
c. CF0 −$2,700, CF1 $1,000, CF2 $1,000, CF3 $1,000, CF4 $1,000 + $350 $1,350
d. N 4, I 9%, PV $787.67
P11-32 Real options and the strategic NPV
LG 6; Intermediate
a. Value of real options value of abandonment value of expansion value of delay
NPVstrategic NPVtraditional Value of real options 1,700 2,200 $500
b. Due to the added value from the options, Rene should recommend acceptance of the capital
c. In general, this problem illustrates that by recognizing the value of real options a project that would
P11-33 Capital rationing—IRR and NPV approaches
LG 6; Intermediate
a. Rank by IRR
Project IRR Initial Investment Total Investment
F 23% $2,500,000 $2,500,000
E 22 800,000 3,300,000
G 20 1,200,000 4,500,000
C 19
B 18
A 17
D 16
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Chapter 11: Capital Budgeting Cash Flows and Risk Refinements 222
b. Rank by NPV (NPV PV – Initial investment)
Project NPV Initial Investment
F $500,000 $2,500,000
A 400,000 5,000,000
Project A can be eliminated because, although it has an acceptable NPV, its initial investment exceeds
the capital budget. Projects F and C require a total initial investment of $4,500,000 and provide a total
c. The internal rate of return approach uses the entire $4,500,000 capital budget but provides $200,000
d. The firm should implement Projects B, F, and G, as explained in part c.
P11-34 Capital Rationing—NPV Approach
LG 6; Intermediate
Project Initial
investment
NPV at
13%
PV
A $300,000 $ 84,000 $384,000
B 200,000 10,000 210,000
b. The optimal group of projects is Projects C, F, and G, resulting in a total net present value of
P11-35 Ethics problem
LG 4; Challenge
Student answers will vary. Some students might argue that companies should be held accountable for any
and all pollution that they cause. Other students may take the larger view that the appropriate goal should be
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223 Gitman/Zutter Principles of Managerial Finance, Brief, Seventh Edition
Case
Case studies are available on www.myfinancelab.com.
Evaluating Cherone Equipment’s Risky Plans for Increasing Its Production Capacity
a. 1. Plan X
CF0 −$2,700,000, CF1 $470,000, CF2 $610,000
Plan Y
CF0 −$2,100,000, CF1 $380,000, CF2 $700,000
2. Using a financial calculator, the IRRs are:
IRRX 16.22%
b. Plan X
CF0 −$2,700,000, CF1 $470,000, CF2 $610,000
Plan Y
CF0 −$2,100,000, CF1 $380,000, CF2 $700,000
The RADR NPV favors selection of Project X.
Ranking
Plan NPV IRR RADRs
X 2 2 1
Y 1 1 2
c. Both NPV and IRR achieved the same relative rankings. However, making risk adjustments through the
d. Plan X
Value of real options 0.25 $100,000 $25,000
NPVstrategic NPVtraditional Value of real options
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Chapter 11: Capital Budgeting Cash Flows and Risk Refinements 224
Plan Y
Value of real options 0.20 $500,000 $100,000
e. With the addition of the value added by the existence of real options, the ordering of the projects is reversed.
Project Y is now favored over Project X using the RADR NPV for the traditional NPV.
f. Capital rationing could change the selection of the plan. Because Plan Y requires only $2,100,000 and Plan X
Spreadsheet Exercise
The answer to Chapter 12’s Isis Corporation spreadsheet problem is located on the Instructor’s Resource Center on
the textbook’s companion website at www.pearsonhighered.com/irc under the Instructor’s Manual.
Group Exercises
Group exercises are available on www.myfinancelab.com.
Exercise 1
Capital investment is revisited in this chapter. A long-term investment project will be detailed across this and the
following two chapters. Students are warned that while this chapter’s exercise is apparently brief, the work is vital
to the work in the following chapters.
The first task is to design two mutually exclusive investment projects. The design should focus on why these
project.
Exercise 2
Risk within long-term investment decisions is the topic of this chapter. The investment projects of the previous two
chapters will now have risk variables introduced. The cash flows estimated previously will now be characterized
by a lack of certainty. Each estimated dollar flow is now assigned three possible levels for three possible states of
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225 Gitman/Zutter Principles of Managerial Finance, Brief, Seventh Edition
Using information from Chapters 10 and 11, the groups are asked to defend their choice of investment projects. As
pointed out in the assignment, groups should use this assignment to defend their choices in the form of documents
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