Exercise 4 (Berk DeMarzo Chapter 7 and 8) Solutions

7-1. Your brother wants to borrow $10,250 from you. He has offered to pay you back $12,500 in a year.
If the cost of capital of this investment opportunity is 8%, what is its NPV? Should you undertake the
investment opportunity? Calculate the IRR and use it to determine the maximum deviation allowable
in the cost of capital estimate to leave the decision unchanged.
$12,500
𝑁𝑃𝑉 = −$10,250 + = $1,324.07
1.08
You should undertake the investment opportunity.
$12,500
𝐼𝑅𝑅 = − 1 = 0.2195 = 21.95%
$10,250
The cost of capital can increase by up to 21.95% - 8% = 13.95% without affecting the decision.

7-5. Bill Clinton reportedly was paid $15 million to write his book My Life. Suppose the
book took three years to write. In the time he spent writing, Clinton could have been paid to
make speeches. Given his popularity, assume that he could earn $8 million per year (paid at the
end of the year) speaking instead of writing. Assume his cost of capital is 10% per year.
a. What is the NPV of agreeing to write the book (ignoring any royalty payments)?
b. Assume that, once the book is finished, it is expected to generate royalties of $5
million in the first year (paid at the end of the year) and these royalties are expected to
decrease at a rate of 30% per year in perpetuity. What is the NPV of the book with the
royalty payments?

a. Timeline:
0 1 2 3

15 –8 –8 –8
8 1
NPV = 15 − (1 − ) = −$4.895 million
0.1 (1.1)3
b. Timeline:
0 1 2 3 4 5 6

15 –8 –8 –8 5 5(1 – 0.3) 5(1 – 03)2

First calculate the PV of the royalties at year 3. The royalties are a declining perpetuity:
5 5
PV5 = = = 12.5 million
0.1 − (− 0.3 ) 0.4

So the value today is

12.5
PVroyalties = = 9.391
(1.1)3
 Now add this to the NPV from part (a),𝑁𝑃𝑉 = −4.895 + 9.391 = $4.496 million.

7-9. You are considering an investment in a clothes distributor. The company needs $105,000 today
and expects to repay you $125,000 in a year from now. What is the IRR of this investment
opportunity? Given the riskiness of the investment opportunity, your cost of capital is 18%. What
does the IRR rule say about whether you should invest?
$125,000
− 1 = 0.1905 = 19.05%
$105,000
Since the IRR > than cost of capital, in this case the IRR rule says you should invest.

7-10. You have been offered a very long term investment opportunity to increase your money one
hundredfold. You can invest $500 today and expect to receive $50,000 in 40 years. Your cost of
capital for this (very risky) opportunity is 16%. What does the IRR rule say about whether the
investment should be undertaken? What about the NPV rule? Do they agree?
$50,000
𝑁𝑃𝑉 = −$500 + = −$367.98 < 0
1.1640
1
$50,000 40
( ) − 1 = 0.122 = 12.2% < 16%
$500
Both rules agree – do not undertake the long-term investment opportunity.

7-21. You are a real estate agent thinking of placing a sign advertising your services at a local bus stop.
The sign will cost $7000 and will be posted for one year. You expect that it will generate additional
revenue of $1120 per month. What is the payback period?
$7,000
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑 = = 6.25 𝑚𝑜𝑛𝑡ℎ𝑠
$1,120

7-26. You work for an outdoor play structure manufacturing company and are trying to decide between
two projects:
Year-End Cash Flows ($ thousands)
Project 0 1 2 IRR
Playhouse -26 15 20 21.2%
Fort -77 39 51 10.6%

You can undertake only one project. If your cost of capital is 5%, use the incremental IRR rule to
make the correct decision.
Timeline:
0 1 2

Playhouse –26 15 20
Fort –77 39 52
Subtract the Playhouse cash flows from the Fort
–51 24 32
$24 $31
𝑁𝑃𝑉 = −$51 + +
1 + 𝐼𝑅𝑅 1 + 𝐼𝑅𝑅 2
 Using an excel spreadsheet to calculate IRR, we find IRR = 4.97%
Since the incremental IRR of 4.97% is less than the cost of capital of 5%, you should take the Playhouse.

8-1. Pisa Pizza, a seller of frozen pizza, is considering introducing a healthier version of its pizza that
will be low in cholesterol and contain no trans fats. The firm expects that sales of the new pizza
will be $22 million per year. While many of these sales will be to new customers, Pisa Pizza
estimates that 37% will come from customers who switch to the new, healthier pizza instead of
buying the original version.
a. Assume customers will spend the same amount on either version. What level of incremental
sales is associated with introducing the new pizza?
b. Suppose that 51% of the customers who will switch from Pisa Pizza’s original pizza to its
healthier pizza will switch to another brand if Pisa Pizza does not introduce a healthier pizza.
What level of incremental sales is associated with introducing the new pizza in this case?

a. Sales of new pizza – Lost sales of original = $22 million – 0.37($22 million) = $13.86 million.
b. Sales of new pizza – Lost sales of original pizza from customers who would not have switched
brands = $22 million – (1 – 0.51)(0.37)($22 million) = $18.01 million.

8-2. Kokomochi is considering the launch of an advertising campaign for its latest dessert product, the
Mini Mochi Munch. Kokomochi plans to spend $4.78 million on TV, radio, and print advertising
this year for the campaign. The ads are expected to boost sales of the Mini Mochi Munch by $9.31
million this year and by $7.30 million next year. In addition, the company expects that new
consumers who try the Mini Mochi Munch will be more likely to try Kokomochi’s other products.
As a result, sales of other products are expected to rise by $3.44 million each year.

Kokomochi’s gross profit margin for the Mini Mochi Munch is 33%, and its gross profit margin
averages 24% for all other products. The company’s marginal corporate tax rate is 40% both this
year and next year. What are the incremental earnings associated with the advertising campaign?
Year 1 2
Incremental Earnings Forecast ($000s)
1 Sales of Mini Mochi Munch 9,310 7,310
Gross margin 33% 33%
2 Other sales 3,440 3,440
Gross margin 24% 24%
3 Cost of goods sold 8,852 7,512
4 Gross profit 3,898 3,238
5 Selling, General & Admin. -4,780
6 Depreciation
7 EBIT -882 3,238
8 Income tax at 40% -353 1295
9 Incremental Earnings -529 1,943