Unformatted text preview: is recovered.
Net present value (NPV)b Present value of cash inflows
investment. Internal rate of return (IRR)b The discount rate that causes NPV $0
(present value of cash inflows equals the
initial investment). aUnsophisticated
bSophisticated Initial Accept if $0.
Reject if $0.
Accept if the cost of capital.
Reject if the cost of capital. technique, because it does not give explicit consideration to the time value of money.
technique, because it gives explicit consideration to the time value of money. 414 PART 3 Long-Term Investment Decisions with regard to the reinvestment of intermediate cash
inflows—cash inflows received prior to termination
of a project. NPV assumes reinvestment of intermediate cash inflows at the more conservative cost of
capital, whereas IRR assumes reinvestment at the
project’s IRR. On a purely theoretical basis, NPV is
preferred over IRR, because NPV assumes the more SELF-TEST PROBLEM
LG2 LG3 LG4 LG5 ST 9–1 LG6 conservative reinvestment rate and does not exhibit
the mathematical problems that often occur when
IRRs are calculated for nonconventional cash flows.
In practice, however, the IRR is more commonly
used because it is consistent with the general preference for rates of return. (Solution in Appendix B)
All techniques with NPV profile—Mutually exclusive projects Fitch Industries
is in the process of choosing the better of two equal-risk, mutually exclusive capital expenditure projects—M and N. The relevant cash flows for each project are
shown in the following table. The firm’s cost of capital is 14%.
Initial investment (CF0)
Year (t) Project N $28,500 $27,000 Cash inflows (CFt) 1 $10,000 $11,000 2 10,000 10,000 3 10,000 9,000 4 10,000 8,000 a.
d. Calculate each project’s payback period.
Calculate the net present value (NPV) for each project.
Calculate the internal rate of return (IRR) for each project.
Summarize the preferences dictated by each measure you calculated, and
indicate which project you would recommend. Explain why.
e. Draw the net present value profiles for these projects on the same set of axes,
and explain the circumstances under which a conflict in rankings might exist. PROBLEMS
LG2 9–1 Payback period Jordan Enterprises is considering a capital expenditure that
requires an initial investment of $42,000 and returns after-tax cash inflows of
$7,000 per year for 10 years. The firm has a maximum acceptable payback
period of 8 years.
a. Determine the payback period for this project.
b. Should the company accept the project? Why or why not? LG2 9–2 Payback comparisons Nova Products has a 5-year maximum acceptable payback period. The firm is considering the purchase of a new machine and must CHAPTER 9 Capital Budgeting Techniques 415 choose between two alternative ones. The first machine requires an initial investment of $14,000 and generates annual after-tax cash inflows of $3,000 for
each of the next 7 years. The second machine requires an initial investment
of $21,000 and provides an annual cash inflow after taxes of $4,000 for 20 years.
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