More Examples

1. (a) What is meant by the term “mutually exclusive projects” ?

(b) Explain why the IRR decision rule could give the wrong result
when comparing mutually exclusive projects.

Answer:
(a) Projects are said to be “mutually exclusive” when the selection of one
automatically eliminates the need for any of the alternatives; eg. choosing
among a number of alternative road designs between the same two points.
(b) It is possible that the ranking of projects using their NPVs changes when
the discount rate changes (“switching”). In this case one project will not be
unambiguously superior to another as a ranking by IRR would suggest.

2. The following net cash flows relate to two projects:

NET CASH FLOWS (IN $ 1,000)

YEAR 0 1 2 3 4 5 6
PROJECT -60 20 20 20 20 20 20
A -72 45 22 20 13 13 13
PROJECT
B

(i) Calculate the NPVs for each project, assuming 10% cost of
capital.
(ii) Assuming that the two projects are independent, would you
accept them if the cost of capital is 15%?
(iii) What is the IRR of each project?
(iv) Which of the two projects would you prefer if they are
mutually exclusive, given a 15% discount rate?

Answer:
(i) NPVA(10%) = 27.11; NPVB(10%) = 26.41
(ii) Yes. NPVA(15%)=15.69;NPVB(15%)=16.43
(iii) IRR(A)=24%; IRR(B)=26%
(iv) Prefer B – higher NPV(15%)
3. Using a spreadsheet generate your own set of Discount and Annuity
Tables for, say, all discount rates between 1% and 20% (at 1
percentage point intervals) and for time periods 1 to 30 (at one time
period intervals), as well as time periods 50 and 100. You should
generate these tables by inserting the numbers for the time periods in
the first column of each row and the discount rates in the first row of
each column, and then inserting the appropriate formula into one cell
of the table – year 1 at 1% - and then copying it to all other cells in
the matrix. (Hint: Do not forget to anchor the references to periods
and discount rates using the “$” symbol.)

Answer:
Write the discount formula into spreadsheet as shown below and then copy
across 20 columns (headed 1% through 20%) and down 50 rows
(headed 1 to 50).

Column B

Row 2

1% 2% 3%
1 =1/(1+B$2)^$A2 0.980 0.971
2 0.980 0.961 0.943
3 0.971 0.942 0.915

4. A firm has a capital budget of $100 which must be spent on one of

two projects, each requiring a present outlay of $100. Project A yields
a return of $120 after one year, whereas Project B yields $201.14
after 5 years. Calculate:

(i) the NPV of each project using a discount rate of 10%;

(ii) the IRR of each project.

What are the project rankings on the basis of these two investment
decision rules? Suppose that you are told that the firm’s reinvestment
rate is 12%, which project should the firm choose?

Answer:
(i)NPV(A) = 9.09; NPV(B) = 24.89, B>A
(ii) IRR(A) = 20%; IRR(B) = 15%, A>B
Using a reinvestment rate of 12% the terminal values are TV(A) = 188.82;
TV(B) = 201.14, hence B>A. Alternatively calculate the IRR of (B-A):
IRR(B-A) = 13.78% > 12%, hence undertake the “extra project” (B-A) ie.
undertake B.

5. A firm has a capital budget of $100 which must be spent on one of

two projects, with any unspent balance being placed in a bank deposit
earning 15%. Project A involves a present outlay of $100 and yields
$321.76 after 5 years. Project B involves a present outlay of $40 and
yields $92 after one year. Calculate:

(i) the IRR of each project;

(ii) the B/C ratio of each project, using a 15% discount rate.

What are the project rankings on the basis of these investment

decision rules? Suppose that if Project B is undertaken its benefit can
be reinvested at 17%; what project should the firm choose? Show
your calculations (spreadsheet printout is acceptable as long as entries
are clearly labelled).

Answer:

(i)IRR(A) = 26.3%; IRR(B) = 130%, B>A

(ii)BCR(A) = 1.6; BCR(B) = 2, B>A
Using a reinvestment rate of 17% the terminal values are: TV(A)=321.76;
TV(B)=293.08, hence A>B. Alternatively calculate the IRR of (A-B):
IRR(A-B)=18.51%>17%, hence undertake the “extra project” (A-B), ie.
undertake A.

6. A firm has a capital budget of $30,000 and is considering three

possible independent projects. Project A has a present outlay of
$12,000 and yields $4, 281 per annum for 5 years. Project B has a
present outlay of $10,000 and yields $4,184 per annum for 5 years.
Project C has a present outlay of $17,000 and yields $5,802 per
annum for 10 years. Funds which are not allocated to one of the
projects can be placed in a bank deposit where they will earn 15%.

(a) Identify six combinations of project investments and a bank

deposit which exhaust the budget.
(b) Which of the above combinations should the firm choose:
 (i) when the reinvestment rate is 15%?
(ii) when the reinvestment rate is 20%?

Explain your answer and show your calculations (spreadsheet printout

is acceptable as long as entries are clearly labelled).

Answer:

To answer these questions it is probably best to compare future values

after 10 years, bearing in mind that projects with a 5-year life will
have terminal value after 5 years which needs to compounded
forward at the reinvestment rate (15% and 20%) to year 10, and the
residual deposited in the bank is always compounded over 10 years
at a 15% interest rate.

Future values are as follows:

15% 20%
A+$18,000 in bank $130,876 $152,092
B+ $20,000 in bank $137,652 $158,387
C+$13,000 in bank $170,394 $203,205
A+B+$8,000 in bank $147,161 $189,112
B+C+$3,000 in bank $186,679 $240,224
A+C+$1,000 in bank. $179,904 $233,929

At a reinvestment rate of 15% or 20% the combination of projects

B+C would be preferred.

7. A public decision-maker has a budget of $100 which must be spent in

the current year. Three projects are proposed, each of which is
indivisible (it is not possible to undertake less than the whole project)
and non-reproducible (it is not possible to construct two versions of the
same project). The discount rate is 10% per annum. The project benefits
and costs are summarized in the following Table:

Project Cost ($) Benefits ($)

Year 0 Year 1 Year 2

A 30 40 0
B 30 0 50
C 70 0 100
(i) Work out the Net Present Value (NPV), Internal Rate of Return
(IRR) and Benefit/Cost Ratio (B/C) for each project;

(ii) Rank the projects according to the NPV, IRR and B/C
investment criteria;

(iii) Which projects should be undertaken to spend the budget:

(a) if the reinvestment rate is 22% per annum;

(b) if the reinvestment rate is 28% per annum?

Answer:

(In answering this question the student should assume that the full
amount of the budget must be exhausted on some combination of the
three projects; ie. it cannot be assumed that some part of the initial
budget is invested at the reinvestment rate. It should also be assumed
that end of year 2 is the terminal year.)

(i)
NPV IRR BCR
A $6.36 33% 1.21
B $11.32 29% 1.38
C $12.64 20% 1.18

(ii) rank by: NPV C, B, A

IRR A, B, C
BCR B,A,C

(iii) Only project A is affected by the reinvestment rate.

(a) At 22% the future value of $40 at end of year 2 is
$48.8.Therefore select projects B and C to maximize return
on $100 investment.
(b) At 28% the future value of $40 at end of year 2 is $51.2.
Therefore select projects A and C to maximize return on
$100 investment.
8. Define and explain the Payback Period Method, the Net Present
Value (NPV) Method and the Internal Rate of Return (IRR) Method.
In your discussion state the criteria for accepting or rejecting an
investment under each rule. Discuss the strengths and weaknesses
associated with the use of each alternative method.

ANSWER:
Payback Period Method
The payback period is the amount of time required to recover the firm's
initial investment in a project. In the case of a mixed stream, the cash
inflows are added until their sum equals the initial investment in the project.
In the case of an annuity, the payback is calculated by dividing the initial
investment by the annual cash inflow.

Criteria: Accept a project if the payback period is less than some preset
limit.

Strengths of the payback include:

o It is simple to use and understand
o It is a crude measure of project risk, and
o It is a crude measure of a project's liquidity.

[Note: liquidity here is a measure of how quick it is to exit an investment,

and how close is the price you get relative to the initial market price when
you start to exit. Projects with shorter payback periods will be more liquid.]

Weaknesses include
o It fails to take into account the time value of money.
o It fails to recognise cash flows that occur after the preset limit
o It assumes cash flows are received on a daily basis
o It fails to select the project that maximises shareholder wealth, etc

[note: here, shareholder wealth is synonymous with the net present value of
future cash flows]

Net Present Value Method:

Net Present Value is the sum of the present values of all the cash flows (CF)
using the project's cost of capital less the initial investment.

Criteria: Accept if NPV>0 and reject if NPV<0

The NPV has many advantages. It considers:

o All the relevant cash flows
o The time value of money
o The risk of the cash flows, and
o Its accept/reject criteria are consistent with the value-maximising
objective.

Disadvantages include
o Not suitable for projects of unequal life.

Internal Rate of Return

Internal rate of return (IRR) on an investment is the discount rate that would
cause the investment to have a net present value of zero. It can be found by
solving the NPV equation given below for the value of k that equates the
present value of cash inflows with the initial investment.

n
CFt
 (1  k )
t 1
t
 CFO

Criteria: Accept if IRR>cost of capital and reject if IRR<cost of capital

The IRR also has many advantages: It considers

o All the relevant cash flows
o The time value of money
o The risk of the cash flows (via cost of capital)
o Its accept/reject criteria will generally - though not always - be
consistent with a value-maximising object.

Disadvantages of IRR method include:

o Manual calculation is hard
o Fails to distinguish between borrowing and lending
o Multiple or no rates of return
o Conflict in ranking with NPV for mutually exclusive projects.

[Note: there is a close relationship between the NPV and IRR methods.
The general formula for both methods is:
n
CFt
 (1  k )
t 1
t
 NPV

The three inputs are cashflows at each time t (CFt), the discount rate (k) and
the NPV.
The difference between NPV and IRR is in which are the inputs and outputs,
as well as the decision criteria:
NPV IRR
Cashflows Input Input
Discount rate Input = required rate Output
NPV Output Input = 0
Decision criteria NPV > 0 IRR > required rate

For non-mutually exclusive projects, NPV and IRR will usually have similar
results:
NPV > 0 means that the project rate of return > required rate
 IRR > required rate means project rate of return > required rate
The conflict between NPV and IRR mainly arises for mutually exclusive
projects (see below) ]

9. ABC corporation is attempting to evaluate the feasibility of investing

$95000 in a project with five years life. The firm has estimated the
associated cash inflows as shown in the following table. The firm has
required rate of return 12 percent.

Year end Cash inflows ($) Cumulative CF

1 20,000 20,000
2 25,000 45,000
3 30,000 75,000
4 35,000 110,000
5 40,000 150,000

a. Calculate payback period for the proposed investment.

b. Calculate NPV for the proposed investment.
c. Calculate IRR (rounded to the nearest whole per cent) for the
proposed investment.
d. Evaluate the acceptability of the proposed investment using NPV and
IRR?

ANSWER:
a. Payback period
3 + ($20,000  $35,000) = 3.57 years

b. PV of cash inflows
Year CF PVIF12%,n PV

1 $20,000 .893 $ 17,860

2 25,000 .797 19,925
3 30,000 .712 21,360
4 35,000 .636 22,260
5 40,000 .567 22,680
$104,085

NPV = PV of cash inflows - Initial investment

NPV = $104,085 - $95,000
NPV = $9,085
c.

$20,000 $25,000 $30,000 $35,000 $40,000

$0  1  2  3  4   $95,000
(1  IRR) (1  IRR) (1  IRR) (1  IRR) (1  IRR) 5

IRR = 15% (15.36%)

d. NPV = $9,085; since NPV > 0; accept

IRR = 15%; since IRR > 12% cost of capital; accept

The project should be implemented since it meets the decision criteria

for both NPV and IRR.

10. Each of following mutually exclusive projects involve an initial

cash outlay of $240,000. The estimated net cash flows for the projects
are:
Project A
Year ($) Project B ($)
1 140000 20000
2 80000 40000
3 60000 60000
4 20000 100000
5 20000 180000

a) Calculate the payback period for both projects. Which project should
be chosen? Why?
b) The company’s required rate of return is 11 percent. Calculate the
NPV and IRR for both projects. Which project should be chosen?
Why?

ANSWER:
a)
Cumulative cash
inflows:
Year Project A Project B
1 140000 20000
 2 220000 60000
3 280000 120000
4 300000 220000
5 320000 400000

PBPA = 2 + (240000-220000) / 60000 = 2 + .3333 = 2.33 years

PBPB = 4 + (240000-220000) / 180000 = 4 + .1111 = 4.11 years
Decision: Project A is better than project B

b) NPV

140 000 80 000 60 000 20 000 20 000

 $240 000 + + +  
NPVA = 1.11 1.112 1.113 1.114 1.115

= $20 000 (to nearest thousand)

20 000 40 000
 $240 000 + +
1.11 1.112
60 000 100 000 180 000
+ + +
NPVB = 1.113 1.114 1.115

= $27 000 (to nearest thousand)

Using the NPV method, project B should be selected.

IRR
IRRA = 16% (rounded)*
IRRB = 14% (rounded)
Using the IRR method, project A should be selected.
This suggests a ranking conflict between the NPV and IRR methods.
 To maximise the value of the company, the NPV method should be used and
therefore project B should be selected.

Note: There are several reasons why NPV and IRR may conflict for
mutually exclusive projects (e.g.
http://www.analystnotes.com/notes/subject.php?id=39

11. SENSITIVITY ANALYSIS EXAMPLE:

Let assume today's date is October 15, 200W and Ron Ross plans on
establishing a retail business, selling chairs. The name of his business will
be the Ron Ross Chair Company. The projected start date for the company
is January 1, 200X. Ron has just completed his forecasted financial
statements for a three year period. ( IE forecasted balance sheet, forecasted
cash flow statement and forecasted income statement). He is now trying to
develop a forecasted sensitivity analysis for the 200X year but seems to be
having some difficulty. Ron calls a local accounting firm and says;

"I have just finished developing my forecasted financial statements for my

business years 200X, 200Y, and 200Z. I am attempting to develop my
forecasted sensitivity analysis for 200X, but I don't know where to start. My
banker suggests the analysis should show the effects on my original
forecasted net income at sales increases of 10% & 20% and at sales
decreases of 10% and 20%. Can you prepare my 200X forecasted sensitivity
analysis for me?"

The accounting firm accepted the challenge and asked Mr. Ross to provide
the following information:

 his 200X forecasted income statement;

 a list of his fixed cost and variable costs;
 the amount he pays his suppliers for each chair; and
 the amount he plans to sell each chair to his customers.
 Ron collects all the requested data and faxes the following information to
the accounting firm.

THE RON ROSS CHAIR COMPANY

FORECASTED INCOME STATEMENT
FOR YEAR ENDING DECEMBER 31, 200X
200X

Sales $80,000
Cost of Goods Sold $48,000

Gross Margin $32,000

Operating Expenses $20,000

(marketing & administrative
expenses)

Net Income Before Taxes $12,000

Additional Information Provided By Ron:

 I will buy preassembled chairs from a wholesaler for $120 each

(shipping included).
 I plan to sell each chair to my customers for $200 each.
 In 200X, I project to sell 400 chairs.
 The only variable cost is my forecasted cost of goods sold.
 All my Operating Expenses (marketing & administrative expenses)
are fixed costs.
 Do not consider income taxes in my sensitivity analysis.
 The accounting firm now has all the information needed to construct a
Sensitivity Analysis for the Ron Ross Chair Company. Remember, the
analysis must show the effect on Ron's forecasted 200X net income before
taxes, assuming his 200X projected sales increase by 10% & 20%. In
RON ROSS CHAIR COMPANY
SENSITIVITY ANALYSIS
FOR THE FORECASTED YEAR 200X

20% 10% 200X 10% 20%

Decrease Decrease original Increase Increase

Revenue:
Sales $64,000 $72,000 $80,000 $88,000 $96,000

Variable Costs:
Cost of Goods Sold $38,400 $43,200 $48,000 $52,800 $57,600

Fixed Costs:
Operating Expenses $20,000 $20,000 $20,000 $20,000 $20,000

Net $5,600 $8,800 $12,000 $15,200 $18,400

income Before Taxes
addition, the sensitivity analysis must show the effect on Ron's forecasted
200X net income before taxes, assuming his 200X projected sales decrease
by 10% & 20%. The 200X Forecasted Sensitivity Analysis, prepared by the
accounting firm for the Ron Ross Company, is presented below.
EXPLANATION:
The third column represents Ron's original forecasted income statement for
200X. Furthermore, after researching the market, existing competitors, costs
of various chair suppliers, operating expenses, and other industry variables,
Ron arrived at the foregoing forecasted sales, costs of goods sold, and
operating expenses. Note: for simplicity, we have totaled each operating
expense into one account and one value - normally each operating expense
and their associated account balance would be listed as a marketing expense
or an administrative expense. At any rate, Ron's original 200X forecasted
income before taxes is $12,000. The net income before taxes is arrived at by
subtracting all forecasted costs and all expenses from the forecasted sales.
Note: we will not consider income taxes in this example.

The first column represents a new forecasted income statement for 200X,
assuming Ron's original sales forecast decreases by 20%. The second
column represents a new forecasted income statement for 200X, assuming
Ron's original forecasted sales decrease by 10%. The forth column
represents a new forecasted income statement for 200X, assuming sales
increase by 10% of Ron's original sales forecast. The fifth column represents
a new forecasted income statement for 200X, assuming sales increase by
20% of Ron's original sales forecast.

The values shown in the sensitivity analysis were arrived at by answering

the following questions.

1. What would sales (in dollars) be if the original forecasted sales were
increased and decreased by 10% & 20%

2. What would variable costs (in dollars) be if the original forecasted sales
were increased and decreased by 10% & 20%

3. What would fixed costs (in dollars) be if the original forecasted sales
were increased and decreased by 10% & 20%

Lets answer each question separately.

QUESTION # 1
What would sales (in dollars) be if the original forecasted sales were
increased and decreased by 10% & 20% ? This question is rather simple to
answer - all you have to do is increase and decrease the original forecasted
sales ($80,000) by 10% and 20%. The calculations are as follows;

$80,000 - 10% = $72,000

$80,000 - 20% = $64,000

$80,000 + 10% = $88,000

$80,000 + 20% = $96,000

After calculating the sales levels at various increases and decreases, the data
is organized as such;

20% 10% 200X 10% 20%

Decrease Decrease original Increase Increase

Revenue:

Sales $64,000 $72,000 $80,000 $88,000 $96,000

There is another way in which these figures could have been calculated.
Recall, Ron told us that his original forecast estimates he will sell 400 chairs
at $200 each (400 chairs x $200 per chair = $80,000 in sales). If he actually
sold 10% less than his original forecast of 400 chairs, then he would sell
only 360 chairs (400 chairs - 10% = 360 chairs). In this case, his sales in
dollars would be $72,000 (360 chairs x $200 per chair) - the same amount
shown above in the sensitivity analysis. You may choose either method,
however, increasing or decreasing the dollars sales is easier and less time
consuming.

QUESTION #2
What would variable costs (in dollars) be if the original forecasted sales
were increased and decreased by 10% & 20%? Remember a variable cost is
a cost or an expense that fluctuates when sales increase or decrease.
Furthermore, if sales increase by 10% for example, variable costs will also
increase by 10%. Since Cost of Goods Sold is considered to be a variable
cost, it will increase and decrease at the same rate of sales. Below illustrates
Ron's variable cost calculations.

$48,000 - 10% = $43,200

$48,000 - 20% = $38,400

$48,000 + 10% = $52,800

$48,000 + 20% = $57,600

After calculating the variable costs at various increases and decreases, the
data is organized as such;

20% 10% 200X 10% 20%

Decrease Decrease original Increase Increase

Revenue:
Sales $64,000 $72,000 $80,000 $88,000 $96,000

Variable Costs:
Cost of Goods Sold $38,400 $43,200 $48,000 $52,800 $57,600

Like sales, the variable costs can be calculated another way. Recall, Ron's
original forecast estimates he will sell 400 chairs and each will be purchased
for $120 (400 chairs x $120 per chair = $48,000 in cost of goods sold). If he
actually sold 10% fewer chairs than his original forecast of 400 chairs, then
he would sell only 360 chairs (400 chairs - 10% = 360 chairs). In this case,
Ron's cost of goods sold (variable costs) would be $43,200 (360 chairs x
$120 per chair) - the same amount shown above in the forecasted sensitivity
analysis. Once again, you may choose either method, however, increasing or
decreasing the dollar amounts tend to be easier and less time consuming.
QUESTION # 3
What would fixed costs (in dollars) be if the original forecasted sales were
increased and decreased by 10% & 20%. Recall, a Fixed Cost is a cost or an
expense that does NOT fluctuate when sales increase or decrease.
Furthermore, if sales increase by 10% for example, fixed costs will not
increase or decrease; instead they will remain the same. Since Ron indicated
that all operating expenses (marketing & administrative expenses) are
considered to be fixed costs, they will remain at the same value shown
regardless if sales increase or decrease. Below illustrates Ron's 200X
Forecasted Fixed Costs at various sales increases and decreases;

20% 10% 200X 10% 20%

Decrease Decrease original Increase Increase

Fixed Costs:

Operating Expenses $20,000 $20,000 $20,000 $20,000 $20,000

Net $5,600 $8,800 $12,000 $15,200 $18,400

Income Before Taxes

That's all there is to developing a sensitivity analysis. By the way, don't

forget to subtract each column's variable costs and fixed costs from each
sales column. This is crucial since it indicates your forecasted net income
(before taxes) at various sales increases & decreases.