Chapter 5 extra problems:

21. Calculating Number of Periods. One of your customers is delinquent on his accounts
payable balance. You’ve mutually agreed to a repayment schedule of $400 per month. You
will charge 1.4 percent per month interest on the overdue balance. If the current balance is
$14,480, how long will it take for the account to be paid off?

The time line is:

0 1 t
…
–$14,480 $400 $400 $400 $400 $400 $400 $400 $400 $400

PVA = C({1 – [1/(1 + r)t]} / r)

$14,480 = $400{[1 – (1/1.014)t ] / .014}

1/1.014t = 1 – [($14,480)(.014) / ($400)]

1.014t = 1 / .4932
t = ln 2.0276 / ln 1.014
t = 50.84 months

22. Calculating EAR. Friendly’s Quick Loans, Inc., offers you “Five for four, or I knock on your
door.” This means you get $4 today and repay $5 when you get your paycheck in one week
(or else). What’s the effective annual return Friendly’s earns on this lending business? If you
were brave enough to ask, what APR would Friendly’s say you were paying?

The time line is:

0 1 t
…
–$4 $5

Here we are trying to find the interest rate when we know the PV and FV. Using the FV equation:

FV = PV(1 + r)
$5 = $4(1 + r)
r = $5/$4 – 1
r = .2500, or 25.00% per week

The interest rate is 25 percent per week. To find the APR, we multiply this rate by the number of
weeks in a year, so:

APR = 52(25%) = 1,300.00%

EAR = [1 + (APR / m)]m – 1

EAR = [1 + .25]52 – 1
EAR = 109,475.4425 or 10,947,544.25%
 Chapter 8

Capital budgeting
“Which investment opportunities should the company undertake? How can these opportunities be
evaluated?”

• There are techniques to evaluate investment opportunities:

1) Net Present Value “NPV”

2) Profitability Index

3) Pay Back Period “PBP”

4) Discounted PBP

5) Internal Rate of Return “IRR”

6) Average Accounting Return “AAR”

 Mutually exclusive or independent

 Mutually exclusive projects:
the firm should only choose one project, since both may provide the same functions or may be
due to limited resources
 Independent projects:
the firm can choose to implement both projects, since they may provide different functions or
funding (resources) might be available

1) NPV

• Is the difference between an investment’s market value (PV of CFs) and its cost

• Net present value is a measure of how much value is created or added today by undertaking an
investment.
• NPV= -Initial cost+ PV of future cash flows

• IC<PV of future CFs, therefore the NPV is positive, accept the investment opportunity

• If IC>PV of future CFs, therefore the NPV is negative, reject the investment opportunity

• If IC=PV of future CFs, therefore the NPV is zero, indifferent to implement the investment
opportunity

• Considered the best measure

 1
1− t
If even CFs use this to get APV= C * (1+r )
r

PV of Future CFs
2) Profitability index =
Initial cost

PI > 1  PV of future CFs> IC  NPV +ve  accept

PI < 1  PV of future CFs< IC  NPV -ve  reject

PI = 1  PV of future CFs = IC  NPV= 0  indifferent

3) Pay Back Period

• The amount of time required for an investment to generate CFs sufficient to recover its initial
cost

• An investment is acceptable if its calculated payback period is less than some pre-specified
number of years

• PBP= No. of years + Remaining cost/CFs of next year

 Advantages:

• Easy to understand

• Adjusts for uncertainty of later CFs

• Biased towards liquidity

Disadvantages:

• Ignores the time value of money (TVM)

• Requires an arbitrary cut-off point

• Ignores the CFs beyond the cut-off point

• Biased against L.T projects, such as R&D and new projects

4. Discounted PBP

• Calculating the discounted PBP solves the time value of money problem

5. IRR

• The most important alternative for NPV

• IRR is the break-even discount rate

• If an investment’s rate is unknown, the IRR could be calculated through setting the NPV at zero

• Based on the IRR rule, an investment is acceptable if the IRR exceeds the required return, since
NPV will be positive (and vice versa) – IRR > Required return
 DISADVANTGES

• Multiple IRR in non-conventional cash flow.

• Difficult in mutually exclusive investments.
• MIRR

6. Average Accounting return (AAR)

¿
AAR= Average∋ Average BV ¿

 Compared with targeted AAR set by the company

AAR > targeted AAR  Accept

AAR < targeted AAR  Reject

3) Project A has cash flows of:

A: 0 1 2 3 4

-60000 23000 28000 19000 9000

Remaining 37000 9000

Cash flows = $23,000 + 28,000

Cash flows = $51,000

during the first two years. The cash flows are still short by $9,000 of recapturing the initial
investment, so the payback for Project A is:

Payback = 2 + ($9,000 / $19,000)

Payback = 2.47 years

Project B has cash flows of:

A: 0 1 2 3 4

-105000 21,000 26,000 29000 260000

Remaining 84000 58000 29000

Cash flows = $21,000 + 26,000 + 29,000

Cash flows = $76,000

during the first three years. The cash flows are still short by $29,000 of recapturing the initial
investment, so the payback for Project B is:

Payback = 3 + ($29,000 / $260,000)

Payback = 3.11 years
Using the payback criterion and a cutoff of 3 years, accept Project A and reject Project B.
Calculate the discounted PBP assuming a discount rate = 10% (cutoff 3 years)

B) DISOUNTED PBP

A: 0 1 2 3 4

-60000 23000 28000 19000 9000

PROJECT A

YEAR 1 = ¿ ¿ = 20,909.09 -39,090.91

YEAR 2 = ¿ ¿ = 23,140.50 -15,950.41

YEAR 3 = ¿ ¿ = 14,274.98 -1,675.43

YEAR 4 = ¿ ¿ = 6,147.12

PBP = 3 + (1,675.43/6,147.12) = 3.27 yrs

PROJECT B

YEAR 1 ¿ ¿ = 19,091.91 -85,909.09

YEAR 2 = ¿ ¿ = 21, 487.60 -64,421.91

YEAR 3 = ¿ ¿ = 21,788.13 -42,633

YEAR 4 = ¿ ¿ = 177,583.35

PBP = 3 + 42,633/177,583.35= 3.24 yrs

Reject both.

7. The NPV of a project is the PV of the outflows plus the PV of the inflows. Since the cash inflows are
an annuity, the equation for the NPV of this project at an 8 percent required return is:
NPV= -IC + PV of future CFs

1
1− t
NPV = –$8,450 + C * (1+r )
r
 1
1− 8
NPV = –$8,450 + ($2,145* (1+8 % ) )
8%

NPV = $3,876.54

At an 8 percent required return, the NPV is positive, so we would accept the project.

The equation for the NPV of the project at a 24 percent required return is:

1
1− 8
NPV = –$8,450 + ($2,145 * (1+24 %) )
24 %

NPV = –$1,111.48

PI= PV of future CFs/IC

PII = ($28,300 / 1.11 + $34,800 / 1.112 + $43,700 / 1.113) / $78,000

PII = 1.099

PIII = ($9,600 / 1.11 + $17,400 / 1.112 + $15,600 / 1.113) / $28,800

PIII = 1.187

The profitability index decision rule implies that we accept Project II, since PIII is greater than the PII.

[Link] NPV of each project is:

NPVI = –$78,000 + $28,300 / 1.11 + $34,800 / 1.112 + $43,700 / 1.113

NPVI = $7,693.02

NPVII = –$28,800 + $9,600 / 1.11 + $17,400 / 1.112 + $15,600 / 1.113

NPVII = $5,377.46

The NPV decision rule implies accepting Project I, since the NPVI is greater than the NPVII.
15. a. The payback period for each project is:

A: 3 + ($110,000 / $325,000) = 3.34 years

B: 1 + ($18,300 / $19,900) = 1.92 years

The payback criterion implies accepting Project B, because it pays back sooner than
Project A.

b. The NPV for each project is:

A: NPV = –$235,000 + $29,000 / 1.13 + $45,000 / 1.13 2 + $51,000 / 1.133 + $325,000 /

1.134
NPV = $60,579.46

B: NPV = –$47,000 + $28,700 / 1.13 + $19,900 / 1.13 2 + $17,300 / 1.133 + $16,200 /

1.134
NPV = $15,908.38
NPV criterion implies we accept Project A because Project A has a higher NPV than Project B.

d. The profitability index for each project is:

A:PI = ($29,000 / 1.13 + $45,000 / 1.132 + $51,000 / 1.133 + $325,000 / 1.134) /$235,000
 PI = 1.258

B: PI = ($28,700 / 1.13 + $19,900 / 1.132 + $17,300 / 1.133 + $16,200 / 1.134) /$47,000

PI = 1.338

Profitability index criterion implies accept Project B because its PI is greater than Project A’s.

4. You’re trying to determine whether or not to expand your business by building a new
manufacturing plant. The plant has an installation cost of $12.5 million, which will be
depreciated straight-line to zero over its four-year life. If the plant has projected net income of
$1,368,000, $1,935,000, $1,738,000, and $1,310,000 over these four years, what is the project’s
average accounting return (AAR)?

Average net income = ($1,368,000 + 1,935,000 + 1,738,000 + 1,310,000) / 4 = $1,587,750

Average book value = ($12,500,000 + 0) / 2 = $6,250,000

AAR = Average net income / Average book value

AAR = $1,587,750 / $6,250,000 = 0.2540, or 25.40%

Targeted AAR 27%