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Case: “Evaluating Cherone Equipment’s Risky Plans for Increasing Its
Production Capacity”
Case studies are available on www.pearson.com/mylab/finance.
a. 1. Plan X
Cash flows: CF0 (project cost) −$2,700,000, CF1 $470,000, CF2 $610,000,
Plan Y
Cash flows: CF0 (project cost) −$2,100,000, CF1 $380,000, CF2 $700,000
2. To use the IRR command in Excel, start by arranging the cash outflows and inflows in adjacent
cells (starting with the outflow— project costs— as a negative number). Proper syntax is:
b. Plan X
Cash flows: CF0 (project cost) −$2,700,000, CF1 $470,000, CF2 $610,000, CF3 $950,000,
CF4 $970,000, and CF5 $1,500,000.
Ranking
Plan NPV IRR RADRs
X 2 2 1
c. Both NPV and IRR produced the same relative rankings before adjusting for risk. Making risk
adjustments with RADRs, however, caused project rankings to reverse. The final choice
would be Plan X because it produces the highest NPV using the risk-adjusted method.
d. Plan X
Value of real options 0.25 $100,000 $25,000
e. With the additional value from the real options, the ordering of projects is reversed. Project Y
is now favored over Project X using the RADR NPV.
f. Capital rationing could change the selection of the plan. Plan Y requires only $2,100,000
Spreadsheet Exercise
Answers to Chapter 12’s Dyno Corporation problem are available on www.pearson.com/mylab/finance.
Group Exercise
Group exercises are available on www.pearson.com/mylab/finance .
The group exercise for this chapter will focus on integrating risk into capital budgeting; specifically,
investment projects from the previous two chapters will now be modified to include risk. Cash flows
estimated previously will no longer be certain. Each estimated dollar flow is now assigned three possible
levels for three possible states of the worlds (pessimistic, most likely, and optimistic). Original estimates
serve as the most likely value. Analysis of these estimates begins with a calculation of the ranges for each
outcome. A simplified RADR is then calculated using the previously determined discount rate. The risk-
adjusted NPV is then calculated.
Using information from Chapters 10, 11, and 12, 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 suitable for presentation to their board of directors. This conclusion should summarize
all the work done across the chapters, and students should take pride in the quantity and quality of their
efforts. It works well to have each student group present their project and decision to the remainder of the
class, who can be viewed as a “board of directors.”
Integrative Case 5: “Lasting Impressions Company”
The Lasting Impressions Company is a commercial printer faced with a replacement decision in which two
mutually exclusive projects have been proposed. The data for each press have been designed to produce
conflicting rankings using the NPV and IRR decision rules. The case tests student understanding of the
techniques as well as the qualitative aspects of risk and return decision-making.
a. 1. Calculation of initial investment for Lasting Impressions Company:
Press A Press B
Installed cost
of new press
Cost of new
press $830,000 $640,000
sale of old
press*
Total (298,400) (298,400)
proceeds—
sale of old
press
Increase in current liabilities (35,000)
Increase in net working capital $ 90,400
2. Depreciation
Year Cost Rate Depreciation
Press A
1 $870,000 0.20 $174,000
2 870,000 0.32 278,400
3 870,000 0.19 165,300
Existing Press
1 $400,000 0.12 (Yr. 4) $48,000
2 400,000 0.12 (Yr. 5) 48,000
3 400,000 0.05 (Yr. 6) 20,000
Operating Cash Inflows
Year
Earnings
before
Depreciat
ion
and
Taxes Depre-
ciation
Earnings
before
Taxes
Earnings
after
Taxes Cash
Flow
Old
Cash
Flow
Incremen
tal
Cash
Flow
Existing
Press
1 $120,0
00 $48,000 $72,000 $43,200 $91,200
2 120,00
048,000 72,000 43,200 91,200
Press A
1 $250,0
00 $174,00
0$76,000 $45,600 $219,60
0$91,200 $128,400
2 270,00
0278,400 8,400 5,040 273,360 91,200 182,160
3 300,00
0165,300 134,700 80,820 246,120 80,000 166,120
Press B
1 $210,0
00 $132,00
0$78,000 $46,800 $178,80
0$91,200 $87,60
0
6 0 33,000 33,000 19,800 13,200 0 13,200
3. Terminal cash flow
Press A Press B
After-tax proceeds—sale of new press
Proceeds on sale of new press $400,000 $330,000
Tax on sale of new press* (142,600
) (118,800)
** Sale price $150,000
Less: Book value (Yr. 6) 0
Cash Flows
Year Press A Press B
Initial investment ($662,000) ($361,600)
1 $128,400 $ 87,600
* Year 5 Press A Press B
Operating cash flow $191,760 $ 85,680
b.
c. Relevant cash flow
Cumulative Cash Flows
Year Press A Press
B
1 $128,400 $87,600
2 310,560 206,880
1. Press A: 4 years [(662,000 644,440) 191,760]
Payback 4 (17,560 191,760)
2. Press A
Cash flows: CF0 (project cost) −$662,000, CF1 $128,400, CF2 $182,160, CF3 $166,120,
Press B
Cash flows: CF0 (project cost) −$361,600, CF1 $87,600, CF2 $119,280, CF3 $96,160,
d.
Data for NPV Profile
Discount Rate NPV
Press A Press B
0% $432,000 $234,000
When the cost of capital is below approximately 15% (where the NPV profiles for the two presses
higher NPV and top ranking (even though it has the lower IRR).
e. a. If the firm has unlimited funds, Press A is preferred.
b. But if the firm is subject to capital rationing, Press B would be preferred if the capital constraint
