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.

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