If the initial cost is 16000 the discounted payback is Discounted payback 3

# If the initial cost is 16000 the discounted payback

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If the initial cost is \$16,000, the discounted payback is: Discounted payback = 3 + (\$16,000 – 4,464.29 – 4,384.57 – 4,270.68) / \$4,448.63 = 3.65 years 2 Tutorial 1 QP 11 Ans: a. The IRR is the interest rate that makes the NPV of the project equal to zero. So, the IRR for each project is: Deepwater Fishing IRR: 0 = C 0 + C 1 / (1 + IRR) + C 2 / (1 + IRR) 2 + C 3 / (1 + IRR) 3 0 = –\$850,000 + \$320,000 / (1 + IRR) + \$470,000 / (1 + IRR) 2 + \$410,000 / (1 + IRR) 3 Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that: IRR = 18.58% Submarine Ride IRR: 0 = C 0 + C 1 / (1 + IRR) + C 2 / (1 + IRR) 2 + C 3 / (1 + IRR) 3 0 = –\$1,650,000 + \$810,000 / (1 + IRR) + \$750,000 / (1 + IRR) 2 + \$690,000 / (1 + IRR) 3 Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that: IRR = 17.81% Based on the IRR rule, the deepwater fishing project should be chosen because it has the higher IRR. b. To calculate the incremental IRR, we subtract the smaller project’s cash flows from the larger project’s cash flows. In this case, we subtract the deepwater fishing cash flows from the submarine ride cash flows. The incremental IRR is the IRR of these incremental cash flows. So, the incremental cash flows of the submarine ride are: Year 0 Year 1 Year 2 Year 3 Submarine Ride –\$1,650,000 \$810,000 \$750,000 \$690,000 Deepwater Fishing –850,000 320,000 470,000 410,000 Submarine – Fishing –\$800,000 \$490,000 \$280,000 \$280,000 3 Tutorial 1 Setting the present value of these incremental cash flows equal to zero, we find the incremental IRR is: 0 = C 0 + C 1 / (1 + IRR) + C 2 / (1 + IRR) 2 + C 3 / (1 + IRR) 3 0 = –\$800,000 + \$490,000 / (1 + IRR) + \$280,000 / (1 + IRR) 2 + \$280,000 / (1 + IRR) 3 Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that: Incremental IRR = 16.84% For investing-type projects, accept the larger project when the incremental IRR is greater than the discount rate. Since the incremental IRR, 16.84 percent, is greater than the required rate of return of 14 percent, choose the submarine ride project. Note that this is not the choice when evaluating only the IRR of each project. The IRR decision rule is flawed because there is a scale problem. That is, the submarine ride has a greater initial investment than does the deepwater fishing project. This problem is corrected by calculating the IRR of the incremental cash flows, or by evaluating the NPV of each project. c. The NPV is the sum of the present value of the cash flows from the project, so the NPV of each project will be: Deepwater Fishing: NPV = –\$850,000 + \$320,000 / 1.14 + \$470,000 / 1.14 2 + \$410,000 / 1.14 3 NPV = \$69,089.81 Submarine Ride: NPV = –\$1,650,000 + \$810,000 / 1.14 + \$750,000 / 1.14 2 + \$690,000 / 1.14 3 NPV = \$103,357.31 Since the NPV of the submarine ride project is greater than the NPV of the deepwater fishing project, choose the submarine ride project. The incremental IRR rule is always consistent with the NPV rule. 4 Tutorial 1 Chapter 6: CQ 2. Incremental Cash Flows Which of the following should be treated as an incremental cash flow when computing the NPV of an investment? a. A reduction in the sales of a company’s other products caused by the investment. Ans: Yes, the reduction in the sales of the company’s other products, referred to as erosion, should be treated as an incremental cash flow. These lost sales are included because they are a cost (a revenue reduction) that the firm must bear if it chooses to produce the new product.  #### You've reached the end of your free preview.

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