Question

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: year 0 = -$6000 | year 1 = $2000 | year 3 = $2000 | year 4 = $2000 | year 5 = $2000

PROJECT B: Year 0 = -$18,000 | Year 1 = $5600 | Year 2 = $5600 | year 3 = $5600 | year 4 = $5600 | year 5 = $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?

Answer 1

Project A: Note the Project A cash flows are only given for Year 1, 3, 4 and 5; hence we assume zero cash flows for Year 2.

Discounted Payback Period not applicable since the NPV is less than 0.

For MIRR, we assume that the reinvestment rate is also 14%.

MIRR = ; where n is the number of time periods - in this case 5.

MIRR = = 11.32%

Project B:

MIRR = = 15.51%

Discounted Payback Period =

= = 4.56 years

Part B. GIven that Project A has negative NPV, IRR less than required rate of 14% and even MIRR less than the required rate it should be rejected. On the other hand, Project B has positive NPV, IRR & MIRR more than 14% , hence Project B should be accepted.

Part C. Project B for the above reasons.

Part D. The conflict can potentially be the result of the fact that the absolute values in Project B are higher than Project A, due to which there can be difference between NPV and IRR.

[Please note that after going through Part D, it seems that the Year 2 cash flows for Project A have been missed. If it was a mistake am adding quick numbers for your reference:

NPV : 866.16 ; IRR : 19.858%; Payback = 3 years; MIRR = 17.12% ; Discounted Payback = 4.157 years. ]