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JCU-MBA-CF

Lecture 5 (Ross Chapter 7)

Capital Budgeting 1:

Net present value and other investment criteria

SOLUTIONS to Tutorial Questions: PRs

3. PAYBACK PERIOD A: 2000 – 1040 = 960; 960/1260 = 0.76 Payback = 1.76 years Payback period B: 2000 – 820 – 880 =300; 300/3800 = 0.08 Payback = 2.08 years

Two-year payback required: Investment A would be accepted.

It is not necessarily the best investment because payback ignores cash flows that occur after the cut-off period, resulting in a bias for short-term projects.

4. Investment A: NPV = –2,000 + 1040/1.06 + 1260/(1.06)2 + 1954/(1.06)3 = $1,743 Investment B: NPV = –2,000 + 820/1.06 + 880/(1.06)2 + 3800/(1.06)3 = $2,748 Investment B is the better investment.

12. A: 100 = 100/(1 + IRR) + 200/(1 + IRR)2 – 100/(1 + IRR)3 Descartes rule of sign states there could be two solutions. IRR = 80.19% or –55.50% B: 100 = 100/(1 + IRR)2 + 200/(1 + IRR)3 IRR = 52.14%

13. Project A: 8,000 = 4,820/(1 +IRR) + 5,860/(1 + IRR)2 IRR = 20.86% Project B: 4,000 = 2,620/(1 + IRR) + 3,440/(1 + IRR)2 IRR = 31.10%

At 0% interest rate NPVA is $2,680 and NPVB is $2,060. At the IRRs the NPVs are both zero so on an NPV/interest profile the plotted curves must cross. If the required rate of return is less than the crossover rate the IRR will incorrectly accept B.

Consider the project A–B 4,000 = 2,200/(1 + IRR) + 2,420/(1 + IRR)2 IRR = 10% = crossover rate. Ping would be indifferent between the two projects at this discount rate.

28. To calculate the IRR we have to use trial and error. The table summarises some possible results:

|Discount rate |Limp |Stumble |
|0% |$55.00 |$50.00