Question

Project P costs $15,000 and is expected to produce benefits (cash flows) of $4,500 per year for five years. Project Q costs $37,500 and is expected to produce cash flows of $11,100 per year for five years. Calculate each project’s (a) net present value (NPV), (b) internal rate of return (IRR), and (c) mod- ified internal rate of return (MIRR). The firm’s required rate of return is 14 percent. Compute the (a) NPV, (b) IRR, (c) MIRR, and (d) discounted payback for the following independent capital budgeting projects. (r = 9%)

Year 0: Project T = ($8000) Project U = ($10,000)

Year 1: Project T = 2,000 Project U = 9,000

Year 2: Project T = 1,000 Project U = 5,000

Year 3: Project T = 7,000 Project U = (3,100)

Which project(s) should the company purchase? Why?

Answer #1

**For any investment decision
to be made sound appraisal techniques should be used to maximise
the shareholder's wealth. A number of such investment criteria (or
capital budgeting techniques) are used to choose from various
investment decision.**

**NPV or Net Present
Value** method is a classic method which recognises the time
value of money and discounts the future cash flows using the
opportunity cost of capital/ (required rate of return). The NPV is
found out be subtracting present values of cash outflows from
present value of cash inflows.

[Excel function used
**‘=NPV(rate,value1,value2…..)**]

**IRR or Internal Rate of
Return** is another discounted cash flow technique which
takes in account the magnitude and timing of cashflows. It gives us
the rate that equates the investment outlay with the present value
of cash inflows received after one period.

[Excel Function used
‘=**IRR(values)**]

**MIRR or Modified
Internal Rate of Return** assumes that a company
reinvests its positive cash flows at the firm's cost of capital and
that the initial outlays are financed at the firm's financing
cost.

[Excel Function used
‘**=MIRR(values,finance_rate,reinvest_rate)**

**Discounted Payback
Method** is a method which
calculates the number of periods taken in recovering the investment
outlays on the present value basis.

As per the question the calculations for the Project P and Project Q are as under:

Based on the above calculation it is
clear that both projects P and Q has equal time of investment and
IRR. But project Q has more NPV than that of Project P. Hence the
company should **purchase Project Q.**

As per the question the calculations for the Project T and Project U are as under:

Based on the above calculation it is clear that the company should Purchase company Project U as it has a higher Internal Rate of Return and a smaller Discounted Payback Period.

You are considering a project with an initial cash outlay of
$100,000 and expected free cash flows of $23,000 at the end of each
year for 6 years. The required rate of return for this project is
10 percent.
a. What is the project’s payback period?
b. What is the project’s discounted payback period?
c. What is the project’s NPV ?
d. What is the project’s PI ?
e. What is the project’s IRR ?
f. What is the project’s...

A project that costs $370,000 is expected to produce $250,000
(year 1) and $185,000 (year 2). If the required rate of return is
12 percent, what is the project's (a) NPV, (b) IRR, and (c)
MIRR?

The IRR evaluation method assumes that cash flows from the
project are reinvested at a rate equal to the project’s IRR.
However, in reality, the reinvested cash flows may not necessarily
generate a return equal to the IRR. Thus, using the modified IRR
approach, you can make a more reasonable estimate of a project’s
rate of return than the project’s IRR can.
Consider the following situation:
Cold Goose Metal Works Inc. is analyzing a project that requires
an initial investment...

The IRR evaluation method assumes that cash flows from the
project are reinvested at the same rate equal to the IRR. However,
in reality the reinvested cash flows may not necessarily generate a
return equal to the IRR. Thus, the modified IRR approach makes a
more reasonable assumption other than the project’s IRR.
Consider the following situation:
Blue Llama Mining Company is analyzing a project that requires
an initial investment of $450,000. The project’s expected cash
flows are:
Year
Cash...

The IRR evaluation method assumes that cash flows from the
project are reinvested at the same rate equal to the IRR. However,
in reality the reinvested cash flows may not necessarily generate a
return equal to the IRR. Thus, the modified IRR approach makes a
more reasonable assumption other than the project’s IRR.
Consider the following situation:
Green Caterpillar Garden Supplies Inc. is analyzing a project
that requires an initial investment of $2,500,000. The project’s
expected cash flows are:
Year...

The IRR evaluation method assumes that cash flows from the
project are reinvested at the same rate equal to the IRR. However,
in reality the reinvested cash flows may not necessarily generate a
return equal to the IRR. Thus, the modified IRR approach makes a
more reasonable assumption other than the project’s IRR.
Consider the following situation:
Green Caterpillar Garden Supplies Inc. is analyzing a project
that requires an initial investment of $400,000. The project’s
expected cash flows are:
Year...

11-11 CAPITAL BUDGETING CRITERIA: MUTUALLY EXCLUSIVE PROJECTS
$225 $225 $50 $49 Project S costs $15,000, and its expected cash
flows would be $4,500 per year for 5 years. Mutually exclusive
Project L costs $37,500, and its expected cash flows would be
$11,100 per year for 5 years. If both projects have a WACC of 14%,
which project would you recommend? Explain

Modified internal rate of return (MIRR)
The IRR evaluation method assumes that cash flows from the
project are reinvested at the same rate equal to the IRR. However,
in reality the reinvested cash flows may not necessarily generate a
return equal to the IRR. Thus, the modified IRR approach makes a
more reasonable assumption other than the project’s IRR.
Consider the following situation:
Fuzzy Button Clothing Company is analyzing a project that
requires an initial investment of $500,000. The project’s...

You are evaluating a capital budgeting project that costs
$25,000 and is expected to generate cash flows equal to $10,000 per
year for four years. The required rate of return is 10 percent.
Compute the project’s (a) net present value, (b) profitability
index, and (c) internal rate of return. (d) Should the project be
purchased?

4. Modified internal rate of return (MIRR)
The IRR evaluation method assumes that cash flows from the
project are reinvested at the same rate equal to the IRR. However,
in reality the reinvested cash flows may not necessarily generate a
return equal to the IRR. Thus, the modified IRR approach makes a
more reasonable assumption other than the project’s IRR.
Consider the following situation:
Cold Goose Metal Works Inc. is analyzing a project that requires
an initial investment of $500,000....

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