BRYAN T.

LLUISMA FIN 3
BSA-4 TTH 5-6:30pm

Part 1.

1. The primary difference between MMR and the regular IRR?

The modified internal rate of return (MIRR) presumes that constructive cash
flows are reinvested to the company’s cost of capital and that the inceptive outlays
are funded at the company’s financing cost. It is a development over IRR and
changes many deficiencies like different IRR is deleted, checks reinvestment price
issue and initiates outcome, that is in a link with the today value method.

Internal Rate of Return or IRR is a measure in capital budgeting

parlance which is used for estimating the profit that can be obtained from the
investments.
Internal rate of return is a type of discount rate that is instrumental in making
the net present value of all the cash flows from any project equal to zero.
In simple words, it can be referred to as the compounded annual rate of return
that can be earned on an investment or a project.

2. The difference between independent and mutually exclusive projects

Independent projects – if the cash flows of one are unaffected by the
acceptance of the other – more than one project may be accepted.

Mutually exclusive projects – if the cash flows of one project can be

adversely impacted by the acceptance of the other– accept one or the other.

3. Identify which is normal cash flow and non-normal cash flow

0 1 2 3 4 5
- + + + + + =normal cash flow
- + + + + - =non-normal cash flow
- - - + + + =normal cash flow
+ + + - - - =normal cash flow
- + + - + - =non-normal cash flow
4. Payback Period and its strength and weakness.
The length of time required for an investment’s net revenues to cover its cost.
defined as the expected number of years required to recover the original investment,
was the first formal method used to evaluate capital budgeting projects.

The number of years required to recover a project’s cost, or “How long

does it take to get our money back?” Calculated by adding project’s cash
inflows to its cost until the cumulative cash flow for the project turns positive

Strengths
 Provides an indication of a project’s risk and liquidity.
 Easy to calculate and understand.

Weaknesses
 Ignores the time value of money.
 Ignores CFs occurring after the payback period.
5. Two reasons NPV profile cross

Size (scale) differences – the smaller project frees up funds at t = 0 for investment. The higher
the opportunity cost, the more valuable these funds, so a high WACC favors small projects.
Timing differences – the project with faster payback provides more CF in early years for
reinvestment. If WACC is high, early CF especially good, NPVS > NPVL.

6. Describe the advantages and disadvantages of the five capital budgeting methods.
PAYBACK
Advantages:
1. A company can have more favourable short-run effects on earnings per share by setting up
a shorter payback period.
2. The riskiness of the project can be tackled by having a shorter payback period as it may
ensure guarantee against loss.
3. As the emphasis in pay back is on the early recovery of investment, it gives an insight to the
liquidity of the project.
Disadvantages:
1. It fails to take account of the cash inflows earned after the payback period.
2. It is not an appropriate method of measuring the profitability of an investment project, as it
does not consider the entire cash inflows yielded by the project.
3. It fails to consider the pattern of cash inflows, i.e., magnitude and timing of cash inflows.
4. Administrative difficulties may be faced in determining the maximum acceptable payback
period
DISCOUNTED PAYBACK
Advantages:
1. Considers the time value of money
2. Considers the riskiness of the project’s cash flow
Disadvantages:
1. No concrete decision criteria that indicate whether the investment increases the firm’s
value
2. Requires an estimate of the cost of capital in order to calculate the payback
3. Ignores cash flows beyond the discounted payback period.

Net present value(NPV)

Advantages:
1. It recognizes the time value of money
2. It considers all cash flows over the entire life of the project in its calculations.
3. It is consistent with the objective of maximizing the welfare of the owners.
Disadvantages:
1. It is difficult to use
2. It presupposes that the discount rate which is usually the firm’s cost of capital is known.
But in practice, to understand cost of capital is quite a difficult concept.
3. It may not give satisfactory answer when the projects being compared involve different
amounts of investment.

Internal Rate of return(IRR)

Advantages:
1. Like the NPV method, it considers the time value of money.
2. It considers cash flows over the entire life of the project.
3. It satisfies the users in terms of the rate of return on capital.
4. Unlike the NPV method, the calculation of the cost of capital is not a precondition.
5. It is compatible with the firm’s maximising owners’ welfare.
Disadvantages:
1. It involves complicated computation problems.
2. It may not give unique answer in all situations. It may yield negative rate or multiple rates
under certain circumstances.
3. It implies that the intermediate cash inflows generated by the project are reinvested at the
internal rate unlike at the firm’s cost of capital under NPV method. The latter assumption
seems to be more appropriate.
Modified internal rate of return
Advantages:
1. Tells whether and investment increases the firm’s value
2. Considers all cash flows of the project
3. Considers the time value of money
4. Considers the riskiness of future cash flows
Disadvantages:
1. Requires an estimate of the cost of capital in order to make a decision
2. May not give the value-maximizing decision when used to compare mutually exclusive
projects
3. May not give the value-maximizing decision when used to choose projects when there is
capital rationing

7. What condition can cause the MIRR and NPV methods to produce conflicting
rankings
NPV and MIRR can produce conflicting ranking, especially for projects that differ in size. Also,
regular the IRR and MIRR can produce ranking conflicts. As the model shows, Project
S's MIRR is larger if WACC is low but higher if WACC is high.
8. Define capital budgeting. Explain why it is important. Differentiate between
security valuation and capital budgeting

Capital budgeting addresses the issue of strategic long-term investment decisions.

Capital budgeting can be defined as the process of analyzing, evaluating, and deciding
whether resources should be allocated to a project or not.
Process of capital budgeting ensure optimal allocation of resources and helps management
work towards the goal of shareholder wealth maximization.
Significance of Capital Budgeting
Considered to be the most important decision that a corporate treasurer has to make.
So much is the significance of capital budgeting that many business schools offer a separate
course on capital budgeting.
In security valuation (bonds), the future return has an impact on the current price. In Capital
Budgeting, future net cash flows over the life of the project are brought into the same context
by deriving the values at the present time, either in absolute or relative terms.
9. How are project classification used in the capital budgeting process
1. Replacement: One category consists of expenditure to replace worn-out or damaged
equipment used in the production of profitable products. Replacement projects are necessary
if the firm is to continue in business.
2. Replacement: Cost reduction. This category includes expenditures to replace serviceable but
obsolete equipment. The purpose here is to lower the costs of labor, materials, and other
inputs such as electricity.
3. Expansion of existing products or markets. Expenditures to increase output of existing
products, or to expand retail outlets or distribution facilities in markets now being served, are
included here.
4. Expansion into new products or markets. These are investments to produce a new product
or to expand into a geographic area are not currently being served.
5. Safety and/or environmental projects-expenditures necessary to comply with government
orders, labor agreements, or insurance policy terms fall into this category.
10. What Reinvestment rate assumptions are built into the NPV, IRR and MIRR methods? Give
explanations for your answer.
 NPV method assumes CFs are reinvested at the WACC.
 IRR method assumes CFs are reinvested at IRR.
 Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV
method is the best. NPV method should be used to choose between mutually exclusive
projects.
 Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed.
 Yes, MIRR is the discount rate that causes the PV of a project’s terminal value (TV) to
equal the PV of costs. TV is found by compounding inflows at WACC.
 MIRR assumes cash flows are reinvested at the WACC.

PART 2:
CAPITAL BUDGETING CRITERIA A firm with a 14% WACC is evaluating two projects
for this year's capital budget. After-tax cash flows, including depreciation, are as follows:

Project A ProjectB

Year 0 -6000 -18000

Year 1 2000 5600

Year2 2000 5600

Year 3 2000 5600

Year 4 2000 5600

Year 5 2000 5600

a. Calculate NPV, IRR, MIRR, payback, and discounted payback for each project.

b. Assuming the projects are independent, which one(s) would you recommend?

c. If the projects are mutually exclusive, which would you recommend?

d. Notice that the projects have the same cash flow timing pattern. Why is there a
conflict between NPV and IRR?
a. Project A:
CF0 = -6000; CF1-5 = 2000; I/YR = 14.

NPV = -$6,000 + ($2,000)(3.4331) = $866.20

Solve for NPVA = $866.16.

IRRA = 19.86%.

MIRR calculation:
0 1 2 3 4 5
| | | | | |
-6,000 2,000 2,000 2,000 2,000 2,000
 1.14
2,280.00
 (1.14)2
2,599.20
 (1.14) 3
2,963.09
 (1.14)4
3,377.92
13,220.21

Using a financial calculator, enter N = 5; PV = -6000; PMT = 0; FV = 13220.21; and solve for
MIRRA = I/YR = 17.12%.
$6,000 = $13,220.21 / (1 + MIRR)5

MIRR = 0.1712 (17.12%)

Payback calculation:
0 1 2 3 4 5
| | | | | |
-6,000 2,000 2,000 2,0002,000 2,000
Cumulative CF: -6,000 -4,000 -2,000 0 2,000 4,000

Regular PaybackA = 3 years.

Payback period = $6,000 / $2,000 = 3.00 years

Discounted payback calculation:

0 1 2 3 4 5
| | | | | |
-6,000 2,000 2,000 2,000 2,000 2,000
Discounted CF: -6,000 1,754.39 1,538.94 1,349.94 1,184.16 1,038.74
Cumulative CF: -6,000 -4,245.61 -2,706.67 -1,356.73-172.57866.17

Discounted PaybackA = 4 + $172.57/$1,038.74 = 4.17 years.

Project B:
CF0 = -18000; CF1-5 = 5600; I/YR = 14.
NPV = -$18,000 + ($5,600) (3.4331) = $1,225.36
Solve for NPVB = $1,255.36
IRRB = 16.80%.

MIRR calculation:
0 1 2 3 4 5
| | | | | |
-18,000 5,600 5,600 5,600 5,600 5,600
 1.14
6,384.00
 (1.14)2
7,277.76
 (1.14)3
8,296.65
 (1.14) 4
9,458.18
37,016.59

Using a financial calculator, enter N = 5; PV = -18000; PMT = 0; FV = 37016.59; and solve for
MIRRB = I/YR = 15.51%.
$18,000 = $37,016.59 / (1 + MIRR)5

MIRR = 0.1551 (15.51%)

Payback calculation:
0 1 2 3 4 5
| | | | | |
-18,000 5,600 5,600 5,600 5,600 5,600
Cumulative CF: -18,000 -12,400 -6,800 -1,200 4,400 10,000

Regular PaybackB = 3 + $1,200/$5,600 = 3.21 years

Discounted payback calculation:

0 1 2 3 4 5
| | | | | |
-18,000 5,600 5,600 5,600 5,600 5,600
Discounted CF: -18,000 4,912.28 4,309.02 3,779.84 3,315.65 2,908.46
Cumulative CF: -18,000 -13,087.72 -8,778.70 -4,998.86 -1,683.21 1,225.25

Discounted PaybackB = 4 + $1,683.21/$2,908.46 = 4.58 years.

Summary of capital budgeting rules results:

Project A Project B
NPV $866.16 $1,225.25
IRR 19.86% 16.80%
MIRR 17.12% 15.51%
Payback 3.0 years 3.21 years
Discounted payback 4.17 years 4.58 years
b. If the projects are independent, both projects would be accepted since both of their NPVs are
positive.

c. If the projects are mutually exclusive then only one project can be accepted, so the project
with the highest positive NPV is chosen. Accept Project B.

d. The conflict between NPV and IRR occurs due to the difference in the size of the projects.
Project B is 3 times larger than Project A.