Question

Jefferson International is trying to choose between the following two mutually exclusive design projects:

Year	Cash Flow A	Cash Flow B
0	-$75,000	-$38,000
1	32,400	17,800
2	30,200	14,200
3	36,600	19,800

The required return is 12 percent.

i) Rank the projects using profitability index (PI) decision rule.

ii) If the company applies the NPV decision rule, which project should it take?

iii) Given your first two answers, which project should the firm accept?

B

Suppose the company is granted a 5-year lease of a land to complete the project. The company is required to restore the land to its former condition after its 5 years tenure. Annual net revenue are expected to be $250,000 for 5 years and the budgeted cost of restoration works is $500,000.

Project	Year	Cash-Flow
Initial Investment	Now	-800,000
Annual Net Revenue	1-4	350,000
Net Cashflow	5	-250,000

Calculate the MIRR for the project, if positive cash flows are expected to be invested at 10% return and money can be borrowed at 7%.

Answer 1

A. i) Profitability Index (PI) has to be found using NPV function in EXCEL

PI=NPV(rate,Year1 to Year3 cashflows)/Year0 cashflow

PI of project A=NPV(12%, Year1 to year3 cashflows)/75000=1.05 (Rank 2)

PI of Project B=NPV(12%, Year1 to year3 cashflows)/38000=1.09 (Rank 1)

ii) To find NPV use NPV function in EXCEL

=NPV(rate,Year1 to Year3 cashflows)-Year0 cashflow

NPV of Project A=NPV(12%,Year1 to Year3 cashflows)-75000=$4054.98

NPV of Project B=NPV(12%,Year1 to Year3 cashflows)-38000=$3306.26

You should take Project A because of higher NPV than Project B

iii) Firm should select the project based on the NPV because it tells that how much profits have been added to the shareholders wealth.

Here Project A adds more value to the shareholders value, hence project A should be selected.

required return	12%
	Cashflow A	Cashflow B
Year0	-75000	-38000
Year1	32400	17800
Year2	30200	14200
Year3	36600	19800
PI	1.05	1.09
NPV	4054.98	3306.26

B. To find MIRR, use MIRR function in EXCEL

=MIRR(Year0 to Year5 cashflows,finance rate,reinvest rate)

finance rate=7%

reinvest rate=10%

=MIRR(Year0 to Year5 cashflows,7%,10%)

MIRR=12.8%

finance rate	7%
reinvest rate	10%
	Cashflows
Year0	-800000
Year1	350000
Year2	350000
Year3	350000
Year4	350000
Year5	-250000
MIRR	12.80%

required return	12%
	Cashflow A	Cashflow B
Year0	-75000	-38000
Year1	32400	17800
Year2	30200	14200
Year3	36600	19800
PI	1.05	1.09
NPV	4054.98	3306.26