2/1/2012

Chapter 12. Solution for Chapter 12 P23 Build a Model

Gardial Fisheries is considering two mutually exclusive investments. The projects' expected net cash
flows are as follows:

Expected Net Cash Flows

Time Project A Project B
0 ($375) ($575)
1 ($300) $190
2 ($200) $190
3 ($100) $190
4 $600 $190
5 $600 $190
6 $926 $190
7 ($200) $0

a. If each project's cost of capital is 12%, which project should be selected? If the cost of capital is
18%, what
project is the proper choice?

@ 12% cost of capital @ 18% cost of capital

Use Excel's NPV function as explained in
WACC = 12% WACC = 18% this chapter's Tool Kit. Note that the range
does not include the costs, which are
NPV A = $226.96 NPV A = $18.24 added separately.

NPV B = $206.17 NPV B = $89.54

At a cost of capital of 12%, Project A should be selected. However, if the cost of capital rises to 18%,
then the choice is reversed, and Project B should be accepted.

b. Construct NPV profiles for Projects A and B.

Before we can graph the NPV profiles for these projects, we must create a data table of project NPVs
relative to differing costs of capital.
NPV
Project A Project B NPV Profiles
$1,000
$226.96 $206.17
0% $900
2%
4% $800
6% Project A
$700
8%
10% $600
12%
14% $500
16%
18% $400 Project B

$300

$200

$100
Cost of Capital
 $600

$500

$400
20%
$300
22%
24% $200
26%
28% $100
Cost of Capital
30%
$0
-5% 0% 5% 10% 15% 20% 25% 30%
c. What is each project's IRR?

We find the internal rate of return with Excel's IRR function:

Note in the graph above that the X-axis intercepts are equal to the two
IRR A = 18.64% projects' IRRs.
IRR B = 23.92%

d. What is the crossover rate, and what is its significance?

Cash flow
Time differential
0 $200
1 ($490)
2 ($390) Crossover rate = 13.14%
The crossover rate represents the cost of
3 ($290) capital at which the two projects value, at
4 $410 a cost of capital of 13.14% is:
5 $410 have the same net present value. In this
6 $736 scenario, that common net present $182
7 ($200)

e. What is each project's MIRR at a cost of capital of 12%? At r = 18%? Hint: note that B is a 6-year project.

@ 12% cost of capital @ 18% cost of capital

MIRR A = 15.43% MIRR A = 18.34%

MIRR B = 17.87% MIRR B = 20.88%

f. What is the regular payback period for these two projects?

Project A
Time period 0 1 2 3 4 5 6 7
Cash flow (375) (300) (200) (100) 600 $600 $926 ($200)
Cumulative cash flow (375) (675) (875) (975) (375) 225 1,151 951
Payback 4.625

Project B
Time period 0 1 2 3 4 5 6 7
Cash flow (575) 190 190 190 190 $190 $190 $0
Cumulative cash flow (575) (385) (195) (5) 185 375 565 565
Payback 3.026

g. At a cost of capital of 12%, what is the discounted payback period for these two projects?
WACC = 12%

Project A
Time period 0 1 2 3 4 5 6 7
Cash flow (375) (300) (200) (100) 600 $600 $926 ($200)
Disc. cash flow (375) (268) (159) (71) 381 340 469 (90)
Disc. cum. cash flow (375) (643) (802) (873) (492) (152) 317 227
Discounted Payback 5.40

Project B
Time period 0 1 2 3 4 5 6 7
Cash flow (575) 190 190 190 190 $190 $190 $0
Disc. cash flow (575) 170 151 135 121 108 96 0
Disc. cum. cash flow (575) (405) (254) (119) 2 110 206 206
Discounted Payback 3.98

h. What is the profitability index for each project if the cost of capital is 12%?

PV of future cash flows for A: $601.96

PI of A: 1.61

PV of future cash flows for B: $781.17

PI of B: 1.36
ear project.