Chapter 9

Additional Q.1. Based on the profitability index rule, should a project with the following cash
flows be accepted if the discount rate is 14 percent? Why or why not?

A. Yes; The PI is 0.96.

B. Yes; The PI is 1.04.
C. Yes; The PI is 1.08.
D. No; The PI is 0.96.
E. No; The PI is 1.04.

Additional Q.2. Alicia is considering adding toys to her gift shop. She estimates that the cost of
inventory will be $7,500. The remodeling expenses and shelving costs are estimated at $1,500.
Toy sales are expected to produce net cash inflows of $1,800, $2,700, $3,200, and $3,400 over
the next four years, respectively. Should Alicia add toys to her store if she assigns a three-year
payback period to this project? Why or why not?
A. No; The payback period is 2.93 years.
B. No; The payback period is 3.38 years.
C. Yes; The payback period is 2.93 years.
D. Yes; The payback period is 3.01 years.
E. Yes; The payback period is 3.38 years.

Additional Q.3. A project has average net income of $5,600 a year over its 6-year life. The initial
cost of the project is $98,000 which will be depreciated using straight-line depreciation to a book
value of zero over the life of the project. The firm wants to earn a minimum average accounting
return of 11.5 percent. The firm should _____ the project because the AAR is _____ percent.
A. accept; 5.71
B. accept; 9.90
C. accept; 11.43
D. reject; 5.71
E. reject; 11.43

4. Value today of Year 1 cash flow = $7,000/1.14 = $6,140.35

Value today of Year 2 cash flow = $7,500/1.142 = $5,771.01
Value today of Year 3 cash flow = $8,000/1.143 = $5,399.77
Value today of Year 4 cash flow = $8,500/1.144 = $5,032.68
For an initial cost of $9,500, the discounted payback is:
Discounted payback = 1 + ($9,500 6,140.35)/$5,771.01 = 1.58 years
For an initial cost of $14,000, the discounted payback is:
Discounted payback = 2 + ($14,000 6,140.35 5,771.01)/$5,399.77 = 2.39 years
For an initial cost of $20,000, the discounted payback is:
Discounted payback = 3 + ($20,000 6,140.35 5,771.01 5,399.77) / $5,032.68
= 3.53 years
10. 0 = 8,000 + 2,200/(1+IRR) + 4,000/(1+IRR) 2 + 8,100/(1+IRR)3
Using a spreadsheet, financial calculator, or trial and error to find the root of the
equation, we find that:
IRR = 28.16%
11. The NPV at 0 percent required return is:
NPV = 8,000 + 2,200 + 4,000 + 8,100 = 6,300
The NPV at a 10 percent required return is:
NPV = 8,000 + 2,200/1.1 + 4,000/1.12 + 8,100/1.13 = 3,391.44
The NPV at a 20 percent required return is:
NPV = 8,000 + 2,200/1.2 + 4,000/1.22 + 8,100/1.23 = 1,298.61
And the NPV at a 30 percent required return is:
NPV = 8,000 + 2,200/1.3 + 4,000/1.32 + 8,100/1.33 = 253.98
Notice that as the required return increases, the NPV of the project decreases. This
will always be

true for projects with conventional cash flows. Conventional cash flows are negative
at the beginning
of the project and positive throughout the rest of the project.
14. a. The equation for the NPV of the project is:
NPV = 280M + 530M/1.12 80M/1.122 = 129,438,775.50
The NPV is greater than 0, so we would accept the project.
b. The equation for the IRR of the project is:
0 = 280M + 530M/(1+IRR) 80M/(1+IRR)2
We know there are two IRRs since the cash flows change signs twice.
From trial and error, the two IRRs are:
IRR = 72.75%, 83.46%
When there are multiple IRRs, the IRR decision rule is ambiguous. Both IRRs are
correct, that
is, both interest rates make the NPV of the project equal to zero. If we are
evaluating whether or
not to accept this project, we would not want to use the IRR to make our decision,
instead we would use NPV.