Question

“Bankrupt” Corporation is in a deep financial crisis. You are one of the financial avengers “Bankrupt” is desperately seeking help from. CEO of the company informed you that he is considering the two risky projects “Thanos” and “Loki” to protect the firm from financial collapse. Both projects have similar risk characteristics. Bankrupt’s WACC is 11%. The initial investments for both the projects are $200 million. Cashflow from the projects are as follows;

Year           1                2                3                4

Thanos       10M           60M           80M           160M

Loki           70M           50M           20M           160M

Now, your job is to explain the following questions in great detail so that the CEO understands your plans to protect the firm.

1. Explain the concept of capital budgeting decisions. How it is different from the firm’s investing decisions.
2. Explain the concepts of independent and mutually exclusive projects
3. What is NPV -explain with an example?
4. Calculate NPV for both the projects and show the steps
5. Explain your decision when Thanos and Loki are mutually exclusive, and when they are independent.
6. WACC has increased to 15%. What change you will see in NPV?
7. What is IRR and how it is different from NPV? What is the IRR for Thanos and Loki? Based on IRR which project you should accept?
8. How is IRR identical to Bond’s YTM?
9. WACC has increased to 15%. What change you will see in IRR? Is it good for the firm?
10. What is the reinvestment assumption for NPV and IRR? Why NPV is better than IRR?
11. Find the MIRR for both projects and explain the difference with IRR.
12. Is MIRR a better measure than NPV? Why and why not?
13. Calculate the pay-back and discounted pay-back for both the project. Discuss the differences between the two methods.

Answer 1

1. Capital Budgeting decisions refer to decide the budget of a company. It is a formal process used for deciding the potential expenditures or investments that are significant in amount.The capital budgeting also includes the decision to invest the current funds for addition, disposition, modification or replacement of fixed asset. The firm's investing decisions involves the decision of from where the amount of money is coming.

2.Independent Exclusive projects are the projects where the cash flow of one are not affected by the acceptance of the other. In the independent exclusive project, more than one project may be accepted. In Mutually Exclusive project, the cash flow of one project can be adversely impacted by the acceptance of the other project. They can accept one or the other project. In big industries the Independent Exclusive Projects are more popular a the companies are running on the independent projects.

3. The Full Form of NPV is Net Present Value. NPS is the present value of an organisation's investment expected cash flows minus the costs of acquiring the investment. Formula for NPS is Cash inflows from investment minus cash outflows.

Example: Company ABC wants to buy Company XYZ. It takes a careful look at company XYZ's projections for the next 10 years. It discounts those projected cash inflows back to the present using its weighted average cost of capital and then subtracts the cost of purchasing company XYZ.

Cost to purchase company XYZ today is $1,000,000

Present value of cash flows from acquiring company XYZ:

Year1 : $200,000

Year2 : $150,000

Year3 : $100,000

Year4 : $75,000

Year5 : $70,000

Year6 : $55,000

Year7 : $50,000

Year8 : $45,000

Year9 : $30,000

Year10 : $10,000

Total : $785,000

Now, we can use the formula;

NPV = Cash inflow - cash outflow

NPV = $785,000 - $1,000,000

NPV = -$215,000

At this point, the management for company ABC would use the NPV to decide whether or not to pursue the acquisition of company XYZ. Because the NPV is negative the, ABC should not acquire company XYZ.

4. NPV for Thanos: Inflow is $200 million

Total outflow is 10M+60M+80M+160M = 310M

So, NPV = $200M-$310M

NPV = -$110M

NPV for Loki: Inflow is $200M

Total Outflow is 70M+50M+20M+160M = 300M

So, NPV = $200M-$300M

NPV = -$100M

5. Thomas and Loki are mutually exclusive when their projects will adversely affect eachother's project and they are independent when their one project will not affect eachother's project.

6. If WACC has increased by 15% the, the NPV will also increased.

7. IRR is Internal Rate of Return. It is a measure of an investment's rate of return. In IRR, the calculation excludes the external factors such as the risk free rate inflation, cost of capital or other financial risk. The result of NPV is in currency however, the result of IRR is in Percentage. NPV method focuses on project surpluses while the IRR is focused on the breakeven cashflow of a project.

8. The IRR is used to review the relative worth of the projects and the YTM (Yield to Maturity) is used in bond analysis to decide the relative value of the bond investments.

9. If WACC is increased by 15% then, the project's rate of return will not exceed its cost and as a result the project should be rejected. Its not good for the firm.

10.The NPV has no reinvestment rate assumption and IRR has reinvestment rate assumption that assumes that the company will reinvest the cash inflows at the IRR's rate of return for the lifetime of the project. The NPV is better than IRR as the reinvestment rate will not change the outcome of the project as NPV has no reinvestment rate assumption.

12. Yes, the MIRR is a better option than NPV because the NPV assumes that periodic cashflows can be reinvested at the NPV discounted rate either at the cost of capital or another risk adjusted discount rate. In addition, when evaluating projects in term of therir financial attractiveness, the two measure may rank their projects differently. This becomes important when capital budget are limited. Hence, the MIRR deals with the weaknesses in NPV.