Question

You have just arrived at a SnappyPrints Inc., a maker of photo printers.  You are working in the Financial Planning department and have joined a team conducting capital budgeting analysis. Snappy is considering two new projects. Project Mini Printer (PMP) and Project High Speed Printer (HSP).  The WACC is 10%.

You will need to decide which project should be chosen.  Use Ch11 text and slides as a guide.

                                   0                      1                      2                      3

                                   |                      |                      |                      |

Project PMP ($    -150                   40                   75                   100

Project PHS ($)   -150                   65                   75                    85

Answer the following questions:

9.     What is the underlying cause of ranking conflicts between NPV and IRR?

10.  What is the reinvestment rate assumption, and how does it affect the NPV versus IRR conflict?

11.  Which method is the best?  Why?

12.  Define the term modified IRR (MIRR).  What is the MIRR for each project?

13.  What are the MIRR’s advantages and disadvantages as compared to the NPV?

14.  What is the payback period?  Find the discounted and regular paybacks for the Projects.

15.  What is the difference between the regular and discounted payback methods?

16.  What are the two main disadvantages of discounted payback?  Is the payback method useful in capital budgeting decisions?  Explain.

Upon further analysis, SnappyPrints believes that sales of the new High-Speed Printer would cannibalize the sales of its existing I-Phone Rapid Print Accessory by 50%, resulting in lost annual cash flow of $25.  

17. How can we define/what do we call this effect?
18. Should this effect be included in the cash flow projections?   
19. If so, which project should be accepted?  

Answer 1

Part (9) As we know that IRR is the rate of interest on which NPV of the project becomes ZERO,where as NPV is the Net Present Value of future cash flow minus initial investment at the beginning of the project.

There are mainly two underlying causes which create conflict between IRR and NPV.

(a) When project size is different i.e.. Initial Investment and their future cash are also different say One project is very big as compared to other so in that case there may be the chances that IRR of smaller project is higher than the IRR of larger project, where as NPV of larger could be more than the smaller. So decision of the management may vary on their requirement.

(b) When timing difference is exist- timing of cash flow from two project is differ such that cash flow from 1st project comes in early stage of the project where as cash flow from 2nd would be on later stage of project.

Part (10) IRR assumes that all the cash flows shall be reinvested at the IRR rate which may not be possible for the funds to be reinvested at the high IRR rates thrown up. Where as in the case of NPV , it is assume that the funds are reinvested at Cost of Capital which is generally lower than the IRR.That is why it is better to choose project having more NPV rather than higher IRR as return from the market always would no be available at IRR rate. ( For reference you can refer part 9(a) explanation).

Part (11) NPV is best for selecting the project. As reinvestment opportunity is not always available in market because IRR rate is much higher than the cost of capital.

Part (12) The MIRR is similar to the IRR, but it is theoretically superior in that it overcomes two weaknesses of the IRR. IRR assumes that all intermediate cash flows are re-invested at IRR as a result of which at times we get multiple IRR. The MIRR correctly assumes that re-investment at the project's cost of capital and avoid the problem of multiple IRR's. In this case all the cash flow has been reinvested at Cost of Capital and it brings at at end of project life then,sum all these future cash flow at the last year of project life.Then MIRR is the discount rate which will cause the sum of future value of all cash inflows to be equal to the firms investment at time zero.

Details of Cash Flow from Project are as follows:-

Year	PMP	HSP
0	-150	-150
1	40	65
2	70	75
3	100	85

As WACC is given i.e. 10%,

For Project PMP.

C1 at the end of year 3 @10%= 40*(1.1)^3= 53.24

C2 at the end of year 3 @10%= 70*(1.1)^2= 84.70

C3 at the end of year 3 @10%= 100*(1.1)^1= 110

So, Total Future Cash Flows = 247.94

Let R1 be the MIRR for Project PMP, Then

PV of Out Flow = PV of Inflow

150= 247.94/(1+R1)^3

(1+R1)^3= 247.94/150

1+R= (1.652933)^(1/3)

R1=1.1824-1=18.24%

For Project PHS

C1 at the end of year 3 @10%= 65*(1.1)^3=86.52

C2 at the end of year 3 @10%= 75*(1.1)^2= 90.75

C3 at the end of year 3 @10%= 85*(1.1)^1= 93.50

So, Total Future Cash Flows = 270.77

Let R2 be the MIRR for Project PMP, Then

PV of Out Flow = PV of Inflow

150= 270.77/(1+R2)^3

(1+R2)^3= 270.77/150

1+R= (1.8051)^(1/3)

R1=1.2176-1=21.76%