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CHAPTER 5
Why Net Present Value Leads to
Better Investment Decisions Than Other Criteria
Answers to Practice Questions
1.
a.
$90.91
.10)
(1
$1000
1000
NPV
A

=
+

=
$
$4,044.73
10)
(1.
$1000
(1.10)
$1000
(1.10)
$4000
(1.10)
$1000
(1.10)
$1000
2000
NPV
5
4
3
2
B
+
=
+
+
+
+
+

=
$
$39.47
10)
(1.
$1000
.10)
(1
$1000
(1.10)
$1000
(1.10)
$1000
3000
NPV
5
4
2
C
+
=
+
+
+
+

=
$
b.
Payback
A
= 1 year
Payback
B
= 2 years
Payback
C
= 4 years
c.
A and B
2.
a.
When using the IRR rule, the firm must still compare the IRR with the
opportunity cost of capital.
Thus, even with the IRR method, one must
specify the appropriate discount rate.
b.
Risky cash flows should be discounted at a higher rate than the rate used
to discount less risky cash flows.
Using the payback rule is equivalent to
using the NPV rule with a zero discount rate for cash flows before the
payback period and an infinite discount rate for cash flows thereafter.
3.
r = 17.44%
0.00%
10.00%
15.00%
20.00%
25.00%
45.27%
Year 0 3,000.00 3,000.00
3,000.00
3,000.00 3,000.00
3,000.00 3,000.00
3,000.00
Year 1
3,500.00 4,239.34
3,500.00
3,181.82 3,043.48
2,916.67 2,800.00
2,409.31
Year 2
4,000.00 5,868.41
4,000.00
3,305.79 3,024.57
2,777.78 2,560.00
1,895.43
Year 3 4,000.00 7,108.06
4,000.00
3,005.26 2,630.06
2,314.81 2,048.00
1,304.76
PV =
0.31
500.00
482.35
437.99
379.64
312.00
0.02
The two IRRs for this project are (approximately): –17.44% and 45.27%
Between these two discount rates, the NPV is positive.
28
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View Full Document4.
a.
The figure on the next page was drawn from the following points:
Discount Rate
0%
10%
20%
NPV
A
+20.00
+4.13
8.33
NPV
B
+40.00
+5.18
18.98
b.
From the graph, we can estimate the IRR of each project from the point
where its line crosses the horizontal axis:
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