Problems 263

7.3╇The Payback Rule

n Payback investment rule: Calculate the amount of time it takes to pay back the initial invest-
ment (the payback period). If the payback period is less than a prespecified length of time,
accept the project. Otherwise, turn it down.
n The payback rule is simple, and favors short-term investments. But it is often incorrect.

7.4╇ Choosing Between Projects

n When choosing among mutually exclusive investment opportunities, pick the opportunity with
the highest NPV.
n We cannot use the IRR to compare investment opportunities unless the investments have the
same scale, timing, and risk.
n Incremental IRR: When comparing two mutually exclusive opportunities, the incremental IRR
is the IRR of the difference between the cash flows of the two alternatives. The incremental IRR
indicates the discount rate at which the optimal project choice changes.

7.5╇ Project Selection with Resource Constraints

n When choosing among projects competing for the same resource, rank the projects by their
profitability indices and pick the set of projects with the highest profitability indices that can
still be undertaken given the limited resource.
Value Created NPV
Profitability Index = =  (7.2)
Resource Consumed Resource Consumed
n The profitability index is only completely reliable if the set of projects taken following the
profitability index ranking completely exhausts the available resource and there is only a single
relevant resource constraint.

Key Terms Data Table p. 270 NPV profile p. 245

incremental IRR p. 256 payback investment rule p. 252
internal rate of return (IRR) payback period p. 252
investment rule p. 248 profitability index p. 260

Further Readers who would like to know more about what managers actually do should consult J. �Graham
and C. Harvey, “How CFOs Make Capital Budgeting and Capital Structure Decisions,” Â�Journal
Reading of Applied Corporate Finance 15(1) (2002): 8–23; S. H. Kim, T. Crick, and S. H. Kim, “Do
Â�Executives Practice What Academics Preach?” Management Accounting â•›68 (November 1986): 49–52;
and P.€Ryan and G. Ryan, “Capital Budgeting Practices of the Fortune 1000: How Have Things
Changed?” Journal of Business and Management 8(4) (2002): 355–364.
For readers interested in how to select among projects competing for the same set of resources,
the following references will be helpful: M. Vanhoucke, E. Demeulemeester, and W. Herroelen,
“On Maximizing the Net Present Value of a Project Under Renewable Resource Constraints,”
Â�Management Science 47(8) (2001): 1113–1121; and H. M. Weingartner, Mathematical Programming
and the Analysis of Capital Budgeting Problems (Englewood Cliffs, NJ: Prentice-Hall, 1963).

Problems All problems are available in . An asterisk (*) indicates problems with a higher level of
difficulty.

NPV and Stand-Alone Projects

1. Your brother wants to borrow $10,750 from you. He has offered to pay you back $12,750 in a
year. If the cost of capital of this investment opportunity is 12%, what is its NPV? Should you
undertake the investment opportunity? Calculate the IRR and use it to determine the maxi-
mum deviation allowable in the cost of capital estimate to leave the decision unchanged.

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 264 Chapter 7╇ Investment Decision€Rules

2. You are considering investing in a start-up company. The founder asked you for $290,000 today
and you expect to get $1,070,000 in eight years. Given the riskiness of the investment oppor-
tunity, your cost of capital is 21%. What is the NPV of the investment opportunity? Should
you undertake the investment opportunity? Calculate the IRR and use it to determine the
maximum deviation allowable in the cost of capital estimate to leave the decision unchanged.
3. You are considering opening a new plant. The plant will cost $95.8 million upfront. After that,
it is expected to produce profits of $31.5 million at the end of every year. The cash flows are
expected to last forever. Calculate the NPV of this investment opportunity if your cost of capi-
tal is 7.4%. Should you make the investment? Calculate the IRR and use it to determine the
maximum deviation allowable in the cost of capital estimate to leave the decision unchanged.
4. Your firm is considering the launch of a new product, the XJ5. The upfront development cost is
$12 million, and you expect to earn a cash flow of $3.1 million per year for the next five years.
Plot the NPV profile for this project for discount rates ranging from 0% to 30%. For what
discount rates is the project attractive?
5. Bill Clinton reportedly was paid $15 million to write his book My Life. Suppose the book took
three years to write. In the time he spent writing, Clinton could have been paid to make speeches.
Given his popularity, assume that he could earn $7.9 million per year (paid at the end of the year)
speaking instead of writing. Assume his cost of capital is 9.4% per year.
a. What is the NPV of agreeing to write the book (ignoring any royalty payments)?
b. Assume that, once the book is finished, it is expected to generate royalties of $5.4 million in
the first year (paid at the end of the year) and these royalties are expected to decrease at a rate
of 30% per year in perpetuity. What is the NPV of the book with the royalty payments?
*6. FastTrack Bikes, Inc. is thinking of developing a new composite road bike. Development will
take six years and the cost is $185,000 per year. Once in production, the bike is expected to
make $259,000 per year for 10 years. Assume the cost of capital is 10%.
a. Calculate the NPV of this investment opportunity, assuming all cash flows occur at the end
of each year. Should the company make the investment?
b. By how much must the cost of capital estimate deviate to change the decision? (Hint : Use
Excel to calculate the IRR.)
c. What is the NPV of the investment if the cost of capital is 13%?
7. OpenSeas, Inc. is evaluating the purchase of a new cruise ship. The ship would cost $497 mil-
lion, and would operate for 20 years. OpenSeas expects annual cash flows from operating the
ship to be $71.1 million (at the end of each year) and its cost of capital is 12.5%.
a. Prepare an NPV profile of the purchase.
b. Estimate the IRR (to the nearest 1%) from the graph.
c. Is the purchase attractive based on these estimates?
d. How far off could OpenSeas’ cost of capital be (to the nearest 1%) before your purchase
decision would change?
8. You are CEO of Rivet Networks, maker of ultra-high performance network cards for gaming
computers, and you are considering whether to launch a new product. The product, the Killer
X3000, will cost $900,000 to develop up front (year 0), and you expect revenues the first year
of $800,000, growing to $1.5 million the second year, and then declining by 40% per year for
the next 3 years before the product is fully obsolete. In years 1 through 5, you will have fixed
costs associated with the product of $100,000 per year, and variable costs equal to 50% of
revenues.
a. What are the cash flows for the project in years 0 through 5?
b. Plot the NPV profile for this investment using discount rates from 0% to 40% in 10%
increments.
c. What is the project’s NPV if the project’s cost of capital is 10%?
d. Use the NPV profile to estimate the cost of capital at which the project would become
unprofitable; that is, estimate the project’s IRR.

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 Problems 265

The Internal Rate of Return Rule

(Note: In most cases you will find it helpful to use Excel to compute the IRR.)
9. You are considering an investment in a clothes distributor. The company needs $109,000 today
and expects to repay you $127,000 in a year from now. What is the IRR of this investment
opportunity? Given the riskiness of the investment opportunity, your cost of capital is 19%.
What does the IRR rule say about whether you should invest?
10. You have been offered a very long term investment opportunity to increase your money one
hundredfold. You can invest $900 today and expect to receive $90,000 in 40 years. Your cost of
capital for this (very risky) opportunity is 21%. What does the IRR rule say about whether the
investment should be undertaken? What about the NPV rule? Do they agree?
11. Does the IRR rule agree with the NPV rule in Problem 3? Explain.
12. How many IRRs are there in part (a) of Problem 5? Does the IRR rule give the right answer in
this case? How many IRRs are there in part (b) of Problem 5? Does the IRR rule work in this case?
13. Professor Wendy Smith has been offered the following deal: A law firm would like to retain her
for an upfront payment of $52,000. In return, for the next year the firm would have access to
8 hours of her time every month. Smith’s rate is $556 per hour and her opportunity cost of
�capital€is 14% (EAR). What does the IRR rule advise regarding this opportunity? What about
the NPV rule?
14. Innovation Company is thinking about marketing a new software product. Upfront costs to
market and develop the product are $5,100,000. The product is expected to generate profits of
$1,000,000 per year for 10 years. The company will have to provide product support expected to
cost $97,000 per year in perpetuity. Assume all income and expenses occur at the end of the year.
a. What is the NPV of this investment if the cost of capital is 5.54%? Should the firm under-
take the project? Repeat the analysis for discount rates of 2.72% and 10.46%.
b. How many IRRs does this investment opportunity have?
c. Can the IRR rule be used to evaluate this investment? Explain.
15. You have 3 projects with the following cash flows:

Year 0 1 2 3 4
Project 1 - 150 20 40 60 80
Project 2 - 825 0 0 7000 - 6500
Project 3 20 40 60 80 - 245

a. For which of these projects is the IRR rule reliable?

b. Estimate the IRR for each project (to the nearest 1%).
c. What is the NPV of each project if the cost of capital is 5%? 20%? 50%?
*16. You own a coal mining company and are considering opening a new mine. The mine itself
will cost $118 million to open. If this money is spent immediately, the mine will generate $22
million for the next 10 years. After that, the coal will run out and the site must be cleaned and
maintained at environmental standards. The cleaning and maintenance are expected to cost
$1.8 million per year in perpetuity. What does the IRR rule say about whether you should
accept this opportunity? If the cost of capital is 7.8%, what does the NPV rule say?
17. Your firm spends $407,000 per year in regular maintenance of its equipment. Due to the eco-
nomic downturn, the firm considers forgoing these maintenance expenses for the next three
years. If it does so, it expects it will need to spend $1.9 million in year 4 replacing failed
equipment.
a. What is the IRR of the decision to forgo maintenance of the equipment?
b. Does the IRR rule work for this decision?
c. For what costs of capital is forgoing maintenance a good decision?

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 266 Chapter 7╇ Investment Decision€Rules

*18. You are considering investing in a new gold mine in South Africa. Gold in South Africa is buried
very deep, so the mine will require an initial investment of $290 million. Once this investment is
made, the mine is expected to produce revenues of $29 million per year for the next 20 years. It will
cost $15 million per year to operate the mine. After 20 years, the gold will be depleted. The mine
must then be stabilized on an ongoing basis, which will cost $4.9 million per year in perpetuity.
Calculate the IRR of this investment. (Hint: Plot the NPV as a function of the discount rate.)
19. Your firm has been hired to develop new software for the university’s class registration system.
Under the contract, you will receive $507,000 as an upfront payment. You expect the develop-
ment costs to be $439,000 per year for the next three years. Once the new system is in place,
you will receive a final payment of $850,000 from the university four years from now.
a. What are the IRRs of this opportunity?
b. If your cost of capital is 10%, is the opportunity attractive?
Suppose you are able to renegotiate the terms of the contract so that your final payment in
year 4 will be $1.2 million.
c. What is the IRR of the opportunity now?
d. Is it attractive at the new terms?
20. You are considering constructing a new plant in a remote wilderness area to process the ore
from a planned mining operation. You anticipate that the plant will take a year to build and
cost $99 million upfront. Once built, it will generate cash flows of $12 million at the end of
every year over the life of the plant. The plant will be useless 20 years after its completion once
the mine runs out of ore. At that point you expect to pay $141 million to shut the plant down
and restore the area to its pristine state. Using a cost of capital of 12%,
a. What is the NPV of the project?
b. Is using the IRR rule reliable for this project? Explain.
c. What are the IRRs of this project?

The Payback Rule

21. You are a real estate agent thinking of placing a sign advertising your services at a local bus stop.
The sign will cost $10,000 and will be posted for one year. You expect that it will generate addi-
tional revenue of $1500 a month. What is the payback period?
22. You are considering making a movie. The movie is expected to cost $8.8 million upfront and
take a year to make. After that, it is expected to make $4.3 million in the first year it is released
and $2.1 million for the following four years. What is the payback period of this investment? If
you require a payback period of two years, will you make the movie? What is the NPV of the
movie if the cost of capital is 10.6%?

Choosing Between Projects

23. You are deciding between two mutually exclusive investment opportunities. Both require the
same initial investment of $9.8 million. Investment A will generate $2.01 million per year
(starting at the end of the first year) in perpetuity. Investment B will generate $1.47 million at
the end of the first year and its revenues will grow at 2.6% per year for every year after that.
a. Which investment has the higher IRR?
b. Which investment has the higher NPV when the cost of capital is 7.8%?
c. In this case, for what values of the cost of capital does picking the higher IRR give the cor-
rect answer as to which investment is the best opportunity?
24. You have just started your summer internship, and your boss asks you to review a recent analysis
that was done to compare three alternative proposals to enhance the firm’s manufacturing facil-
ity. You find that the prior analysis ranked the proposals according to their IRR, and recom-
mended the highest IRR option, Proposal A. You are concerned and decide to redo the analysis
using NPV to determine whether this recommendation was appropriate. But while you are
confident the IRRs were computed correctly, it seems that some of the underlying data regard-
ing the cash flows that were estimated for each proposal was not included in the report. For
Proposal B, you cannot find information regarding the total initial investment that was required

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 Problems 267

in year 0. And for Proposal C, you cannot find the data regarding additional salvage value that
will be recovered in year 3. Here is the information you have:
Proposal IRR Year 0 Year 1 Year 2 Year 3
A 60.0% - 100 30 153 88
B 55.0% ? 0 206 95
C 50.0% - 100 37 0 204 + ?
Suppose the appropriate cost of capital for each alternative is 10%. Using this information,
determine the NPV of each project. Which project should the firm choose?
Why is ranking the projects by their IRR not valid in this situation?
25. Use the incremental IRR rule to correctly choose between the investments in Problem 23 when
the cost of capital is 7%. At what cost of capital would your decision change?
26. You work for an outdoor play structure manufacturing company and are trying to decide
between the following two projects:
Year-End Cash Flows ($ thousands)
Project 0 1 2 IRR
Playhouse - 27 16 21 22.7%
Fort - 77 40 50 10.6%
You can undertake only one project. If your cost of capital is 8%, use the incremental IRR rule
to make the correct decision.
*27. You are evaluating the following two projects:
Year-End Cash Flows ($ thousands)
Project 0 1 2
X - 35 23 22
Y - 90 44 66
Use the incremental IRR to determine the range of discount rates for which each project is
optimal to undertake. Note that you should also include the range in which it does not make
sense to take either project.
28. Consider two investment projects, both of which require an upfront investment of $12 million
and pay a constant positive amount each year for the next 10 years. Under what conditions can
you rank these projects by comparing their IRRs?
29. You are considering a safe investment opportunity that requires a $780 investment today, and
will pay $570 two years from now and another $580 five years from now.
a. What is the IRR of this investment?
b. If you are choosing between this investment and putting your money in a safe bank account
that pays an EAR of 5% per year for any horizon, can you make the decision by simply
comparing this EAR with the IRR of the investment? Explain.
30. Facebook is considering two proposals to overhaul its network infrastructure. They have received
two bids. The first bid, from Huawei, will require a $17 million upfront investment and will
generate $20 million in savings for Facebook each year for the next three years. The second bid,
from Cisco, requires a $97 million upfront investment and will generate $60€million in savings
each year for the next three years.
a. What is the IRR for Facebook associated with each bid?
b. If the cost of capital for this investment is 16%, what is the NPV for Facebook of each bid?
Suppose Cisco modifies its bid by offering a lease contract instead. Under the terms of the
lease, Facebook will pay $30 million upfront, and $35 million per year for the next three
years. Facebook’s savings will be the same as with Cisco’s original bid.
c. Including its savings, what are Facebook’s net cash flows under the lease contract? What is
the IRR of the Cisco bid now?
d. Is this new bid a better deal for Facebook than Cisco’s original bid? Explain.

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 268 Chapter 7╇ Investment Decision€Rules

Project Selection with Resource Constraints

31. Natasha’s Flowers, a local florist, purchases fresh flowers each day at the local flower market.
The buyer has a budget of $970 per day to spend. Different flowers have different profit mar-
gins, and also a maximum amount the shop can sell. Based on past experience the shop has
estimated the following NPV of purchasing each type:

NPV per Bunch Cost per Bunch Max. Bunches

Roses $2 $15 25
Lilies 9 24 10
Pansies 6 31 10
Orchids 20 84 5

What combination of flowers should the shop purchase each day?

32. You own a car dealership and are trying to decide how to configure the showroom floor. The
floor has 2000 square feet of usable space. You have hired an analyst and asked her to estimate
the NPV of putting a particular model on the floor and how much space each model requires:

Model NPV Space Requirement (sq. ft.)

MB345 $3000 200
MC237 5000 250
MY456 4000 240
MG231 1000 150
MT347 6000 450
MF302 4000 200
MG201 1500 150

In addition, the showroom also requires office space. The analyst has estimated that office space
generates an NPV of $14 per square foot. What models should be displayed on the floor and
how many square feet should be devoted to office space?
33. Kaimalino Properties (KP) is evaluating six real estate investments. Management plans to buy
the properties today and sell them five years from today. The following table summarizes the
initial cost and the expected sale price for each property, as well as the appropriate discount rate
based on the risk of each venture.

Project Cost Today Discount Rate Expected Sale Price in Year 5

Mountain Ridge $ 3,000,000 15% $18,000,000
Ocean Park Estates 15,000,000 15% 75,500,000
Lakeview 9,000,000 15% 50,000,000
Seabreeze 6,000,000 8% 35,500,000
Green Hills 3,000,000 8% 10,000,000
West Ranch 9,000,000 8% 46,500,000

KP has a total capital budget of $18,000,000 to invest in properties.

a.What is the IRR of each investment?
b.What is the NPV of each investment?
c.Given its budget of $18,000,000, which properties should KP choose?
d.Explain why the profitably index method could not be used if KP’s budget were $12,000,000
instead. Which properties should KP choose in this case?
*34. Orchid Biotech Company is evaluating several development projects for experimental drugs.
Although the cash flows are difficult to forecast, the company has come up with the following
estimates of the initial capital requirements and NPVs for the projects. Given a wide variety of
staffing needs, the company has also estimated the number of research scientists required for
each development project (all cost values are given in millions of dollars).

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 Data Case 269

Project Number Initial Capital Number of Research Scientists NPV

I $10 2 $10.1
II 15 3 19.0
III 15 4 22.0
IV 20 3 25.0
V 30 12 60.2

a. Suppose that Orchid has a total capital budget of $60 million. How should it prioritize these
projects?
b. Suppose in addition that Orchid currently has only 12 research scientists and does not �anticipate
being able to hire any more in the near future. How should Orchid prioritize these projects?
c. If instead, Orchid had 15 research scientists available, explain why the profitability index
ranking cannot be used to prioritize projects. Which projects should it choose now?
Data Case
Your success in business thus far has put you in a position to purchase a home for $500,000 located
close to the university you attend. You plan to pay a 20% down payment of $100,000 and borrow the
remaining $400,000. You need to decide on a mortgage, and realize you can apply the skills you have
acquired in the last several chapters to evaluate your choices. To find the available options, go to www
.bankrate.com. Select “Mortgages,” then “Mortgage Rates.” For location, choose the nearest large
city; for mortgage type, choose purchase (not refinance). Consider 30-year fixed rate mortgages with
20% down, and assume your credit score is the highest possible.
Consider all the options by selecting loans with “All points.” Update rates and sort by “Rate”
to find the loan with the lowest rate (not APR). Record the rate, points, fees, “APR,” and monthly
payment for this loan.
Next consider only loans with “0 points” and find the loan with the lowest fees. Again, record the
rate, points, fees, “APR,” and monthly payment for this loan.
First, use the annuity formula or PMT function in Excel to verify the monthly payment for each
loan. (Note that to convert the “Rate” to a monthly interest rate you must divide by 12. Your result
may differ slightly due to rounding.)
Next, calculate the actual amount you will receive from each loan after both fees and points.
(Note that fees are a fixed dollar amount; points are also paid up front and are calculated as a % of
the loan amount.) Using this net amount as the amount you will receive (rather than $400,000),
show that the quoted “APR” of the loan is the effective IRR of the loan once all fees are included
(you may use the Rate function in Excel, or calculate the NPV at the quoted “APR”).
Compare the loans, assuming you will keep them for 30 years, as follows:
1. Compute the incremental cash flows of the lower rate loan; that is, determine how much more
you will pay in fees, and how much you will save on your monthly payment.
2. What is the payback period of the lower rate loan? That is, how many years of lower monthly
payments will it take to save an amount equal to the higher fees?
3. What is the IRR associated with paying the higher fees for the lower rate loan? (Again, the RATE
function can be used.)
4. Plot the NPV profile of the decision to pay points for the lower rate loan. Do the NPV rule and
the IRR rule coincide?
Next, compare the loans assuming you expect to keep them for only 5 years:
5. Compute the final payment you will need to make to pay off each loan at the end of 5 years
(Hint: the FV function in Excel can be used). Which loan will be more expensive to repay?
6. Including the incremental cost to repay the loan after 5 years, what is the IRR and NPV profile
associated with paying points now?
Create a data table showing the NPV of paying points for different horizons (1 to 30 years) and
�different discount rates (0% to the IRR in (3) above). What can you conclude about whether it is a good
idea to pay points?
Suppose the bank gives you the option to increase either loan amount so that for either loan, you will
receive $400,000 today after all fees and points are paid. How would this affect your decision to pay points?
Note: Updates to this data case may be found at www.berkdemarzo.com.

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