Question

Project P costs $15,000 and is expected to produce benefits (cash flows) of $4,500 per year for five years. Project Q costs $37,500 and is expected to produce cash flows of $11,100 per year for five years. Calculate each project’s (a) net present value (NPV), (b) internal rate of return (IRR), and (c) mod- ified internal rate of return (MIRR). The firm’s required rate of return is 14 percent.  Compute the (a) NPV, (b) IRR, (c) MIRR, and (d) discounted payback for the following independent capital budgeting projects. (r = 9%)

Year 0: Project T = ($8000) Project U = ($10,000)

Year 1: Project T = 2,000 Project U = 9,000

Year 2: Project T = 1,000 Project U = 5,000

Year 3: Project T = 7,000 Project U = (3,100)

Which project(s) should the company purchase? Why?

Answer 1

For any investment decision to be made sound appraisal techniques should be used to maximise the shareholder's wealth. A number of such investment criteria (or capital budgeting techniques) are used to choose from various investment decision.

NPV or Net Present Value method is a classic method which recognises the time value of money and discounts the future cash flows using the opportunity cost of capital/ (required rate of return). The NPV is found out be subtracting present values of cash outflows from present value of cash inflows.

[Excel function used ‘=NPV(rate,value1,value2…..)]

IRR or Internal Rate of Return is another discounted cash flow technique which takes in account the magnitude and timing of cashflows. It gives us the rate that equates the investment outlay with the present value of cash inflows received after one period.

[Excel Function used ‘=IRR(values)]

MIRR or Modified Internal Rate of Return assumes that a company reinvests its positive cash flows at the firm's cost of capital and that the initial outlays are financed at the firm's financing cost.

[Excel Function used ‘=MIRR(values,finance_rate,reinvest_rate)

Discounted Payback Method is a method which calculates the number of periods taken in recovering the investment outlays on the present value basis.

As per the question the calculations for the Project P and Project Q are as under:

Based on the above calculation it is clear that both projects P and Q has equal time of investment and IRR. But project Q has more NPV than that of Project P. Hence the company should purchase Project Q.

As per the question the calculations for the Project T and Project U are as under:

Based on the above calculation it is clear that the company should Purchase company Project U as it has a higher Internal Rate of Return and a smaller Discounted Payback Period.