Principles of Managerial Finance

(Dana P.) #1

442 PART 3 Long-Term Investment Decisions


The Problem
A simple example will demonstrate the basic problem of noncomparability
caused by the need to select the best of a group of mutually exclusive projects
with differing usable lives.

EXAMPLE The AT Company, a regional cable television company, is evaluating two proj-
ects, X and Y. The relevant cash flows for each project are given in the following
table. The applicable cost of capital for use in evaluating these equally risky proj-
ects is 10%.

Table Use The net present value of each project at the 10% cost of capital is
calculated by finding the present value of each cash inflow, summing them, and
subtracting the initial investment from the sum of the present values.

NPVX[$28,000(0.909)][$33,000(0.826)][$38,000(0.751)]$70,000
($25,452$27,258$28,538)$70,000
$81,248$70,000
$


1


1


,


2


4


8


NPVY [$35,000(0.909)][$30,000(0.826)][$25,000(0.751)]
[$20,000 (0.683)][$15,000(0.621)][$10,000(0.564)]$85,000
($31,815$24,780$18,775$13,660$9,315$5,640)$85,000
$103,985$85,000
$


1


8


,


9


8


5


The NPV for project X is $11,248; that for project Y is $18,985.

Calculator Use Employing the preprogrammed NPV function in a financial
calculator, we use the keystrokes shown at the left for project X and for project
Y to find their respective NPVs of $11,277.24 and $19,013.27.

Spreadsheet Use Comparison of the net present values of two projects with
unequal lives also can be calculated as shown on the following Excel spreadsheet.

Project X Project Y

Initial investment $70,000 $85,000
Year Annual cash inflows

1 $28,000 $35,000
2 33,000 30,000
3 38,000 25,000
4 — 20,000
5 — 15,000
6 — 10,000

11277.24

 70000 CF 0
CF 1

CF 3
I
NPV

CF 2

28000
33000
38000
10

Solution

Input Function

Project X

19013.27

 85000 CF 0
CF 1

CF 3
CF 4
CF 5
CF 6
I
NPV

CF 2

35000
30000
25000
20000
15000
10000
10

Solution

Input Function

Project Y
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