Tutorial 8: Answers

Questions
1. 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) ]
Problems

1. 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

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

c. $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.
2. Each of following mutually exclusive projects involve an initial cash outlay of
$240,000. The estimated net cash flows for the projects are:
Year Project A ($) 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 companys 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 + + +
1.11 1.11 2 1.11 3 1.11 4
1.11 5

NPVA =

= $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)
http://www.analystnotes.com/notes/subject.php?id=39)
]

3. Projects with Unequal Lives Annualised Net Present Value (ANPV) Approach
ABC firm is considering to invest in one of three mutually exclusive projects X, Y
and Z. The initial investment and annual net cash inflows over the life of each project
are shown in the following table:

Project X Project Y Project Z

Initial investment $78,000 $52,000 $66,000
Year Net cash flows
1 $17,000 $28,000 $15,000
2 $25,000 $38,000 $15,000
3 $33,000 ------ $15,000
4 $41,000 ------ $15,000
5 ------ ------ $15,000
6 ------ ------ $15,000
7 ------ ------ $15,000
8 ------ ------ $15,000

All the projects have equal risk and firms required rate of return for these projects is
14%.
a. Calculate the NPV for each project over its life. Rank the projects in
descending order based on NPV.
b. Calculate the Equivalent Annual Value (EAV) for each project over its life.
Rank the projects in descending order based on EAV.
c. Compare and contrast your findings in a & b above. Which project would you
recommend the firm to purchase? Why?

a. Project X
Year CF PVIF14%,n PV

1 $ 17,000 .877 $ 14,909

2 25,000 .769 19,225
3 33,000 .675 22,275
4 41,000 .592 24,272
$ 80,681
NPV = $80,681 - $78,000 = $2,681
Calculator solution: $2,698.32
 Project Y
Year CF PVIF14%,n PV

1 $ 28,000 .877 $ 24,556

2 38,000 .769 29,222
$ 53,778

NPV = $53,778 - $52,000

NPV = $1,778
Calculator solution: $1,801.17

Project Z
PVn = PMT x (PVIFA14%,8 yrs.)
PVn = $15,000 x 4.639
PVn = $69,585

NPV = PVn - Initial investment

NPV = $69,585 - $66,000
NPV = $3,585
Calculator solution: $3,582.96

Rank Project
1 Z
2 X
3 Y
NPVj
b. Equivalent Annualised NPV or EAV j =
PVIFAk%, nj

Project X
EAV = $2,681 2.914 (14%,4 yrs.)
EAV = $920.04

Project Y
EAV = $1,778 1.647 (14%,2 yrs.)
EAV = $1,079.54

Project Z
EAV = $3,585 4.639 (14%, 8 yrs.)
EAV = $772.80

Rank Project
1 Y
2 X
3 Z

c. Project Y should be accepted. The results in a and b show the difference in NPV
when differing lives are considered.

[Note: Projects with long-dated lives will likely have higher NPVs than shorter-dated
projects.

The Annualised Net Present Value approach (or Equivalent Annuity approach)
recognises the fact that the longer-dated project will tie up capital for a longer
period compared to the shorter-dated project - the shorter-dated project allows the
investor to get back their original investment faster, which then allows them to
reinvest in another project.
The Annualised NPV approach expresses each project as an equivalent annual
cashflow (EAC) having the same total NPV as the project. This allows the equivalent
annual cashflows to be compared between projects see below.]