Question

You are on the staff of Camden Inc. The CFO believes project acceptance should be based on the NPV, but Steve Camden, the president, insists that no project should be accepted unless its IRR exceeds the project’s risk-adjusted WACC. Now you must make a recommendation on a project that has a cost of $15,000 and two cash flows: $110,000 at the end of Year 1 and -$100,000 at the end of Year 2. The president and the CFO both agree that the appropriate WACC for this project is 10%. At 10%, the NPV is $2,355.37, but you find two IRRs, one at 6.33% and one at 527.01%, and a MIRR of 11.32%. Which of the following statements best describes your optimal recommendation, i.e., the analysis and recommendation that is best for the company and least likely to get you in trouble with either the CFO or the president?

Group of answer choices

You should recommend that the project be rejected because (1) its NPV is positive and (2) it has two IRRs, one of which is less than the WACC, which indicates that the firm’s value will decline if the project is accepted.

You should recommend that the project be rejected because, although its NPV is positive, it has an IRR that is less than the WACC.

You should recommend that the project be rejected because its NPV is negative and its IRR is less than the WACC.

You should recommend that the project be rejected because, although its NPV is positive, its MIRR is less than the WACC, and that indicates that the firm’s value will decline if it is accepted.

You should recommend that the project be accepted because (1) its NPV is positive and (2) although it has two IRRs, in this case it would be better to focus on the MIRR, which exceeds the WACC. You should explain this to the president and tell him that that the firm’s value will increase if the project is accepted.

Answer 1

If we closely look at cash flows, we find that it is not a regular capital budgeting problem.

There is an outflow, then again cash inflow and then again cash out flow. So it is a non-conventional cash flow problem.

As there are 2 negative signs, we are sure that there are 2 IRRs but which one is correct one is difficult to say.

Generally when NPV is positive, it is adding value to shareholders so it should be accepted.

But yes we can also look for MIRR which is greater than WACC and so we can say that project should be accepted.

so last option is correct one.

Correct answer :

You should recommend that the project be accepted because (1) its NPV is positive and (2) although it has two IRRs, in this case it would be better to focus on the MIRR, which exceeds the WACC. You should explain this to the president and tell him that that the firm’s value will increase if the project is accepted.