Question

Using a WACC of 15%, apply four capital budgeting techniques to evaluate the project, assuming the Free Cash Flows are as follows: Years Free Cash Flows 0 $ (252,000.00) 1 $ 118,625.00 2 $ 127,125.00 3 $ 181,000.00 The four techniques are NPV, IRR, MIRR, and discounted Payback. Assume the reinvestment rate to be 8% for the MIRR. Also, assume that the business will only accept projects with a payback period of two and half years or less.

Answer 1

NPV is the Net present value of all cashflows associated with the project at time t=0, discounted at WACC or required rate of return.

IRR is the rate of return at which NPV is equal to 0.

Modified internal rate of return (MIRR) assumes that positive cash flows are reinvested at the firm's cos of capital, and the initial outlays are financed at the firm's financing cost. By contrast, the IRR assumes the cash flows from a project are reinvested at the IRR.

A discounted payback period gives the number of years it takes to break even from undertaking the initial expenditure, bydiscounting future cash flows and recognizing the time value of money.

NPV and Discounted payback could be calculated manually. However, we would need Excel for calculating MIRR and IRR.

Year	Cashflows	Discounted Cashflow
0	$ (252,000.00)	= -252000/(1 + 0.15)^0 = $ (252,000.00)
1	$    118,625.00	= 118625/(1 + 0.15)^1 = $ 103,152.17
2	$    127,125.00	= 127125/(1 + 0.15)^2 = $ 96,124.76
3	$    181,000.00	= 181000/(1 + 0.15)^3 = $ 119,010.44

NPV = - $252,000 + $103,152.17 + $96,124.76 + $119,010.44 = $66,287.38

Positive NPV means the project will add value to the firm and hence should be selected.

Discounted Payback

For discounted payback, we need to calculate the time taken by the discounted cashflows to re-earn invested amount.

In 2 years, amount earned = $103,152.17 + $96,124.76 = $199,276.94. $52,723.06 more is required to re-earn the invested amount of $252,000. But last year discounted cashflow is $119,010.44, which is more than what we require.

So, it takes 1 year to earn $119,010.44

Fraction of year it would take to earn $52,723.06 = $52,723.06/$119,010.44 = 0.44

Hence discounted payback = 2 years + 0.44 year = 2.44 years

This is less than 2.5 threshold of payback period (given in question). Hence the project is selectable based on discounted payback period as well.

IRR and MIRR calculation in Excel are shown below. NPV calculations are also shown

Now, the rule for both IRR and MIRR remain the same. Since both are higher than WACC (return generated higher than cost incurred on capital), hence the project is selectable by both IRR and MIRR approach as well.