I. You have two possible projects with a cost of capital of 8% and the following
ID: 2779833 • Letter: I
Question
I. You have two possible projects with a cost of capital of 8% and the following expected cash flows: Expected Net Cash Flows Year Franchise L Franchise S ($100) 10 60 80 (S100) 70 50 20 3 a) What is the NPV of each project? According to NPV, which project would you choose if they are mutually exclusive? NPV-L 24.21 NPV-S = 23.56 I would choose Franchise L What is each project's IRR? According to IRR, which project would you choose? IRR-L = 18.13% IRR-S = 23.56% I would choose Franchise S. b) What is each project's Modified IRR? If you use Modified IRR as your decision rule, which do you choose? Does this mirror the previous decision based on NPV or IRR? c) d) What is the Profitability Index for each project? PI = NPV/initial investment PI-L 24.21/100 = 24.21% What is the payback period for each project? What is the discounted payback for each project? Payback period-L 2+30/80-2.375 years Payback period-S 1+30/50 -1.6 years e) ** For each method above, consider the pros and cons of the method used for project decision- making.Explanation / Answer
(c) MIRR =( FV(Positive cashflow , cost of capital)/ PV(Initial outlays, financing cost))^n - 1
To calculate the MIRR of the project , assume that the positive cash flows will be reinvested at the 8% cost of capital
= 10*(1+.08)^2 + 60*(1+.08)^1 + 80*(1+.08)^0
= 10*1.1664 + 60*1.08+80*1
= 11.664+64.8+80
= 156.464
MIRR = (156.464/100)^(1/3) -1
= 1.56464^(1/3)-1
= 1.160927 - 1
= 16.09%
Now MIRR of project S
Future value of the positive cash flow is computed as -
= 70*(1+.08)^2+50*(1+.08)^1+20*(1+.08)^0
= 155,648
Initial cash outlay =100
No MIRR= (155.648/100)^(1/3) -1
= 1.158905 - 1
= 15.89%
Project L should be chosen.
IRR and NPV gives an overly optimistic picture of the potential of the project, while the MIRR gives a more realistic evaluation of the project.
Calcualtion of Discounted Payback period -
Dis. Payback period(L)= 2 + (100-60.70)/(124.21-60.70)*12
= 2 + (39.30/63.51)*12
= 2 years 7.42 months
For Project S -
Dis. payback period = 1+(100-64.81)/(107-64.81)
= 1 + (35.19 / 42.87)*12
= 1 year and 9.84 months
In case of any clarification requird please comment.
year Franchise L Discouting @8% PV Cum. PV 1 10 0.93 9.26 9.26 2 60 0.86 51.44 60.70 3 80 0.79 63.51 124.21