Chapter 10 (Part 2): NET PRESENT VALUE, PROFITABILITY INDEX, INTERNAL RATE OF RETURN

10-1

The Tiger Co. is considering an expansion of its product line and has estimated the following cash flows associated with such an expansion.

The initial cash outflow would be $1,950,000 and the project would generate cash inflows of $450,000 per year for 6 years.

The required rate of return is 9%.

a. Calculate the projects Profitability Index. Should the project be accepted or rejected? Explain.

b. Calculate the projects Net Present Value. Should the project be accepted or rejected? Explain.

c. Calculate the projects Internal Rate of Return. Interpret its meaning. Explain over what range of discount rates the project should be accepted and when it should be r

The Lion Co. is considering two independent projects: A and B.

The required rate of return on both projects is 11%.

The expected annual cash inflows from each project are as follows:

Project A Project B

Initial outlay, Year 0 -$50,000 -$70,000

Inflow, Year 1 $12,000 $13,000

Inflow, Year 2 $12,000 $13,000

Inflow, Year 3 $12,000 $13,000

Inflow, Year 4 $12,000 $13,000

Inflow, Year 5 $12,000 $13,000

Inflow, Year 6 $12,000 $13,000

a. Calculate the Profitability Index for each project. Which project(s) should be accepted? Explain.

Project A:

Project B:

b. Calculate the Net Present Value for each project. Which project(s) should be accepted? Explain.

Project A:

Project B:

c. Calculate the Internal Rate of Return for each project. Interpret its meaning. Which project(s) should be accepted? Explain.

Project A:

Project B:

The Fox Co. is considering three projects: A, B and C. The applicable discount rate is 20%.

Project A Project B Project C

Initial outlay, Year 0 -$1,000 -$10,000 -$5,000

Inflow, Year 1 $600 $5,000 $1,000

Inflow, Year 2 $300 $3,000 $1,000

Inflow, Year 3 $200 $3,000 $2,000

Inflow, Year 4 $100 $3,000 $2,000

Inflow, Year 5 $500 $3,000 $2,000

a. Calculate the Profitability Index for each project. Which project(s) should be accepted? Explain.

Project A:

Project B:

Project C:

b. Calculate the Net Present Value for each project. Which project(s) should be accepted? Explain.

Project A:

Project B:

Project C:

c. Calculate the Internal Rate of Return for each project. Interpret its meaning. Which project(s) should be accepted? Explain.

Project A:

Project B:

Project C:

d. If these projects are independent, which project(s) will you go ahead with? Explain.

e. If these projects are mutually exclusive, which project(s) will you go ahead with? Explain.

The Bear Co. is considering building a new factory to produce aluminum baseball bats.

This project would require an initial cash outlay of $5 million and would generate annual cash inflows of $1 million per year for 8 years.

a. Calculate the projects Net Present Value and its Profitability Index given the following:

Required rate of return of 7%. Can the project be accepted in this case? Explain.

Required rate of return of 9%. Can the project be accepted in this case? Explain.

Required rate of return of 11%. Can the project be accepted in this case? Explain.

Required rate of return of 13%. Can the project be accepted in this case? Explain.

b. What can you observe from your calculations above? How does the Net Present Value react to the changes in the discount rate? How does the Profitability Index react to the changes in the discount rate?

c. Calculate the projects Internal Rate of Return. Interpret its meaning. Explain over what range of discount rates the project should be accepted and when it should be rejected?

10-6

The Wolf Co. is considering purchasing new machinery for its business line.

This investment requires initial cash outlay of $150,000 and would generate cash inflow of $20,000 per year for 15 years.

a. If the required rate of return is 5%, calculate the projects Net Present Value and its Profitability Index.

b. If the required rate of return is 10%, calculate the projects Net Present Value and its Profitability Index.

c. Would the project be accepted under part (a) or (b)? Explain.

d. Calculate the projects Internal Rate of Return. Interpret its meaning. Explain over what range of discount rates the project should be accepted and when it should be rejected?