In: Finance
List four procedures for screening projects and deciding which to accept or reject? What does a net present value profile tell you, and how is it constructed? How does the IRR enter into the net present value profile? What is the difference between the IRR and the MIRR? What are mutually exclusive projects? How might they complicate the capital-budgeting process?
Part A> 4 procedures for screening projects are:
a. Net Present Value: Net Present Value calculates the present value by discounting all the future cash flows at a given discount rate. If NPV is positive, it means that project is profitable and hence we should always accept the project.
b. Internal Rate of Return: IRR is the discount rate or the firm's cost of capital which makes the PV of the project's cash inflows equal to the initial investment. We accept the project, if IRR >= cost of capital.
c. Modified Internal Rate of Return: MIRR is similar to IRR but it considers the cost of capital as the reinvested rate for a firm’s positive cash flows and the financing cost as the discount rate for the firm’s negative cash flows. We accept the project if MIRR > Expected Return.
d. Payback Period: It is defined as the number of years required to recover a project cost. We accept the project, if payback period is less than the maximum accepted payback period.
Part B> Net Present Value calculates the present value of the project by discounting all the future cash flows at a given discount rate. We discount the Cash inflows of each individual year at a given discount rate and add all the PV values. Then the initial investment amount is deducted from it to achieve the NPV value.
Part C> Just like NPV, IRR is also a criteria to judge whether we should accept a project or not. It gives us an idea at what rate, out NPV turns zero and hence is very helpful.
Part D> MIRR is similar to the internal rate of return (IRR). The difference is it considers the cost of capital as the reinvested rate for a firm’s positive cash flows and the financing cost as the discount rate for the firm’s negative cash flows and hence portrays more accurately than IRR.
Part E> mutually exclusive projects are those projects in which the investment decision is dependent on the relative merit of the projects. It is different to the independent projects in which one project has no relation with investment decision to the other project.