Chapter 10
The Basics of Capital Budgeting: Evaluating Cash Flows
ANSWERS TO END-OF-CHAPTER QUESTIONS
10-1 a. Capital budgeting is the whole process of analyzing projects and deciding whether
they should be included in the capital budget. This process is of fundamental
importance to the success or failure of the firm as the fixed asset investment decisions
b. Mutually exclusive projects cannot be performed at the same time. We can choose
c. The net present value (NPV) and internal rate of return (IRR) techniques are
discounted cash flow evaluation techniques because they explicitly recognize the time
value of money. NPV is the present value of the project’s expected future cash flows
d. The modified internal rate of return (MIRR) assumes that cash flows from all projects
e. An NPV profile is the plot of a project’s NPV versus its cost of capital. The crossover
f. Capital projects with nonnormal cash flows have a large cash outflow either
g. The mathematics of the NPV method imply that project cash flows are reinvested at
h. A replacement chain is a method of comparing mutually exclusive projects that have
unequal lives. Each project is replicated such that they will both terminate in a
common year. If projects with lives of 3 years and 5 years are being evaluated, the
3-year project would be replicated 5 times and the 5-year project replicated 3 times;
10-3 The NPV is obtained by discounting future cash flows, and the discounting process
10-4 This question is related to Question 10-3 and the same rationale applies. With regard to
10-5 Generally, the failure to employ common-life analysis in such situations will bias the
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
10-1 NPV = -$40,000 + $9,000[(1/I) – (1/(I × (1 + I)N)]
FV Inflows:
PV FV
01234567
||||||||
9,000 9,000 9,000 9,000 9,000 9,000 9,000.00
9,900.00
Financial calculator: Obtain the FVA by inputting N = 7, I/YR = 11, PV = 0, PMT =
10-4 PV = $9,000[(1/I) – (1/(I × (1 + I)N)]
Financial calculator: Find present value of future cash flows by inputting N = 7, I/YR =
PI = PV of future cash flows/Initial cost
10-5 Since the cash flows are a constant $9,000, calculate the payback period as:
12%
10-6 The project’s discounted payback period is calculated as follows:
Year Annual CF
Discounted CF
(@11%)
Cumulative
Discounted CF
0 -40,000 -40,000.00
1 9,000 8,108.11 (31,891.89)
The discounted payback period is 6 +
93.334,4$
16.925,1$
years, or 6.44 years.
10-7 a. Project A: Using a financial calculator, enter the following:
CF0 = -15000000
CF1 = 5000000
CF2 = 10000000
CF3 = 20000000
I/YR = 10; NPV = $12,836,213.
Project B: Using a financial calculator, enter the following:
CF0 = -15000000
I/YR = 10; NPV = $15,954,170.
b. Using the data for Project A, enter the cash flows into a financial calculator and solve
Using the data for Project B, enter the cash flows into a financial calculator and solve
10-8 Truck:
NPV = -$17,100 + $5,100(PVIFA14%,5)
Financial calculator: Input the appropriate cash flows into the cash flow register, input
Financial calculator: Input the appropriate cash flows into the cash flow register and then
FV Inflows:
PV FV
012345
||||||
5,100 5,100 5,100 5,100 5,100
5,814
Financial calculator: Obtain the FVA by inputting N = 5, I/YR = 14, PV = 0, PMT =
Pulley:
Financial calculator: Input the appropriate cash flows into the cash flow register, input
14%
MIRR: PV Costs = $22,430.
FV Inflows:
PV FV
012345
||||||
7,500 7,500 7,500 7,500 7,500
8,550
Financial calculator: Obtain the FVA by inputting N = 5, I/YR = 14, PV = 0, PMT =
10-9 Electric-powered:
NPVE= -$22,000 + $6,290[(1/i) – (1/(i × (1 + i)n)]
Financial calculator: Input the appropriate cash flows into the cash flow register, input
Financial calculator: Input the appropriate cash flows into the cash flow register and then
solve for IRR = 18%.
Gas-powered:
I/YR = 12, and then solve for NPV = $3,057.
Financial calculator: Input the appropriate cash flows into the cash flow register and then
The firm should purchase the electric-powered forklift because it has a higher NPV than
14%
10-10 Financial calculator solution, NPV:
Project S
Inputs 5 12 3000 0
Project L
Inputs 5 12 7400 0
Financial calculator solution, IRR:
Financial calculator solution, MIRR:
Project S
Inputs 5 12 0 3000
N I/YR FVPMTPV
N I/YR FVPMTPV
N I/YR FVPMTPV
Project L
Inputs 5 12 0 7400
N I/YR FVPMTPV
10-11 Because both projects are the same size you can just calculate each project’s MIRR and
choose the project with the higher MIRR. (Remember, MIRR gives conflicting results
from NPV when there are scale differences between the projects.)
Project X: 0 1 2 3 4
|||||
-5,000 1,000 1,500 2,000 4,000.00
5,000 17.49% = MIRRX
Project Y: 0 1 2 3 4
|||||
-5,000 4,500 1,500 1,000 500.00
1,120.00
1,881.60
Thus, since MIRRY > MIRRX, Project Y should be chosen.
Alternative step: You could calculate NPVs, see that Project X has the higher NPV, and
just calculate MIRRX.
12%
12%