Principles of Managerial Finance

410 PART 3 Long-Term Investment Decisions

TABLE 9.6 Project Cash Flows

After Reinvestment

Reinvestment Rate

10% 15%

Initial investment $170,000

Year Operating cash inflows

1$0$0

200

3 248,720 258,496

NPV @ 10% $ 16,867 $ 24,213

IRR 13.5% 15.0%

TABLE 9.7 Preferences Associated with

Extreme Discount Rates and

Dissimilar Cash Inflow

Patterns

Cash inflow pattern

Lower early-year Higher early-year

Discount rate cash inflows cash inflows

Low Preferred Not preferred

High Not preferred Preferred

higher cash inflows in the early years tend to be preferred at higher discount

rates. Why? Because at high discount rates, later-year cash inflows tend to be

severely penalized in present value terms. For example, at a high discount rate,

say 20 percent, the present value of $1 received at the end of 5 years is about 40

cents, whereas for $1 received at the end of 15 years it is less than 7 cents.

Clearly, at high discount rates a project’s early-year cash inflows count most in

terms of its NPV. Table 9.7 summarizes the preferences associated with extreme

discount rates and dissimilar cash inflow patterns.

EXAMPLE Bennett Company’s projects A and B were found to have conflicting rankings at

the firm’s 10% cost of capital (as depicted in Figure 9.4). If we review each proj-

ect’s cash inflow pattern as presented in Table 9.1 and Figure 9.1, we see that

although the projects require similar initial investments, they have dissimilar cash

inflow patterns. Table 9.7 indicates that project B, which has higher early-year

cash inflows than project A, would be preferred over project A at higher discount

rates. Figure 9.4 shows that this is in fact the case. At any discount rate in excess