SOLUTION TO INTEGRATIVE PROBLEM

1. Capital budgeting decisions involve investments requiring rather large cash outlays at the
beginning of the life of the project and commit the firm to a particular course of action
over a relatively long time horizon. As such, they are both costly and difficult to reverse,
both because of: (1) their large cost; (2) the fact that they involve fixed assets which
cannot be liquidated easily.
2. Axiom 5: The Curse of Competitive MarketsWhy It's Hard to Find Exceptionally
Profitable Projects deals with the problems associated with finding profitable projects.
When we introduced that axiom we stated that exceptionally successful investments
involve the reduction of competition by creating barriers to entry either through product
differentiation or cost advantages. In effect, without barriers to entry, whenever
extremely profitable projects are found competition rushes in, driving prices and profits
down unless there is some barrier to entry.
3. Payback period
A
= 3 years +
000 , 50
000 , 20
years = 3.4 years
Payback Period
B
=
000 , 40
000 , 110
years = 2.75 years
Project B should be accepted while project A should be rejected.
4. The disadvantages of the payback period are: 1) ignores the time value of money,
2)ignores cash flows occurring after the payback period, 3)selection of the maximum
acceptable payback period is arbitrary.
5. Discounted Payback Period Calculations, Project A:
Cumulative
Undiscounted Discounted Discounted
Year Cash Flows PVIF
12%,n
Cash Flows Cash Flows
0 -$110,000 1.000 -$110,000 -$110,000
1 20,000 .893 17,860 -92,140
2 30,000 .797 23,910 -68,230
3 40,000 .712 28,480 -39,750
4 50,000 .636 31,800 -7,950
5 70,000 .567 39,690 31,740
Discounted Payback Period = 4.0 + 7,950/39,690 = 4.20 years.
Discounted Payback Period Calculations, Project B:
Cumulative
Undiscounted Discounted Discounted
Year Cash Flows PVIF
12%,n
Cash Flows Cash Flows
0 -$110,000 1.000 -$110,000 -$110,000
1 40,000 .893 35,720 -74,280
2 40,000 .797 31,880 -42,400
3 40,000 .712 28,480 -13,920
4 40,000 .636 25,440 11,520
5 40,000 .567 22,680 34,200
Discounted Payback Period = 3.0 + 13,920/25,440 = 3.55 years.
Using the discounted payback period method and a 3-year maximum acceptable project
hurtle, neither project should be accepted.
6. The major problem with the discounted payback period comes in setting
the firm's maximum desired discounted payback period. This is an
arbitrary decision that affects which projects are accepted and which ones
are rejected. Thus, while the discounted payback period is superior to the
traditional payback period, in that it accounts for the time value of money
in its calculations, its use should be limited due to the problem
encountered in setting the maximum desired payback period. In effect,
neither method should be used.
7. NPV
A
=
t
t
n
1 t
k) (1
FCF

+

=
- IO
= $20,000(PVIF
12%, 1 year
) + $30,000 (PVIF
12%, 2 years
)
+ $40,000(PVIF
12%, 3 years
) + $50,000 (PVIF
12%, 4 years
)
+ $70,000(PVIF
12%, 5 years
) - $110,000
= $20,000(.893) + $30,000 (.797) + $40,000 (.712) + $50,000
(.636) + $70,000 (.567) - $110,000
= $17,860 + $23,910 + $28,480 + $31,800 + $39,690 - $110,000
= $141,740-$110,000
= $31,740
NPV
B
= $40,000(PVIFA
12%, 5 years
) - $110,000
= $40,000(3.605) - $110,000
= $144,200-$110,000
= $34,200
Both projects should be accepted
8. The net present value technique discounts all the benefits and costs in
terms of cash flows back to the present and determines the difference. If
the present value of the benefits outweighs the present value of the costs,
the project is accepted, if not, it is rejected.
9. PI
A
=
IO
k) (1
FCF
t
t
n
1 t
|
|
|
|
|
.
|

\
|
+

=

=
000 , 110 $
740 , 141 $

= 1.2885
PI
B
=
000 , 110 $
200 , 144 $

= 1.3109
Both projects should be accepted
10. The net present value and the profitability index always give the same
accept reject decision. When the present value of the benefits outweighs
the present value of the costs the profitability index is greater than one,
and the net present value is positive. In that case, the project should be
accepted. If the present value of the benefits is less than the present value
of the costs, then the profitability index will be less than one, and the net
present value will be negative, and the project will be rejected.
11. For both projects A and B all of the costs are already in present dollars
and, as such, will not be affected by any change in the required rate of
return or discount rate. All the benefits for these projects are in the future
and thus when there is a change in the required rate of return or discount
rate their present value will change. If the required rate of return
increased, the present value of the benefits would decline which would in
turn result in a decrease in both the net present value and the profitability
index for each project.
12. IRR
A
= 20.9698%
IRR
B
= 23.9193%
13. The required rate of return does not change the internal rate of return for a
project, but it does affect whether a project is accepted or rejected. The
required rate of return is the hurdle rate that the project's IRR must exceed
in order to accept the project.
14. The net present value assumes that all cash flows over the life of the project are
reinvested at the required rate of return, while the internal rate of return implicitly
assumes that all cash flows over the life of the project are reinvested over the remainder
of the project's life at the IRR. The net present value method makes the most acceptable,
and conservative assumption and thus is preferred.
15. Project A:

t
t
n
0 t k) (1
ACOF

+

=
=
n
n
0 t
t n
t
MIRR) (1
k) (1 ACIF
+
+

$110,000 =
5
A
12% 12%
12% 12%
) MIRR (1
$70,000
year) 1 , IF $50,000(FV years) 2 , IF $40,000(FV
years) 3 , IF $30,000(FV years) 4 , IF $20,000(FV
+
+
+ +
+

$110,000 =
5
A
) MIRR (1
000 , 70 $ ) 120 . 1 ( 000 , 50 $ ) 254 . 1 ( 000 , 40 $
) 405 . 1 ( 000 , 30 $ ) 574 . 1 ( 000 , 20 $
+
+ + +
+

$110,000 =
5
A
) MIRR (1
000 , 70 $ 000 , 56 $ 160 , 50 $ 150 , 42 $ 480 , 31 $
+
+ + + +

$110,000 =
5
A
) MIRR 1 (
790 , 249 $
+

MIRR
A
= 17.8247%

Project B:
$110,000 =
5
B
,5years
12%
) MIRR (1
) IFA $40,000(FV
+

$110,000 =
5
B
) MIRR (1
353) $40,000(6.
+

$110,000 =
5
B
) MIRR (1
$254,120
+

MIRR
B
= 18.2304%
Both projects should be accepted because their MIRR exceeds the required rate of return. The
modified internal rate of return is superior to the internal rate of return method because MIRR
assumes the reinvestment rate of cash flows is the required rate of return.