Question

Company ABC is considering purchasing of New Packaging Machine system to improve its

existing packaging process. In order to analyze the feasibility of this project the company needs

the help Investment analysist to evaluate this project. In order to evaluate this proposal the

company has shared following information.

The project requires an initial investment of Rs.1000000 in equipment and it will be depreciated

to zero on Straight line basis over 5 years. This system will generate 80,000 units each year which

will produce Revenue of Rs. 1500000 each year for next 5 years. However the variable cost

charged to this project is estimated as Rs. 5 per unit and fixed cost is expected to be Rs. 30000 per

year. The relevant Tax Rate is 38%. Calculate the Operating Cash Flows for this company.

This project will require an additional Rs.35000 to invest in Networking Capital so that company

can efficiently run its daily operations. You are also supposed to calculate projected cash flows

for this company. After calculating these estimated cash flows what do you think; should the

company proceed for this new product if the required rate of return of this company is

16%?Being an investment analysist you are also supposed to calculate the profitability index

and discounted payback period for this project. It will help the management to check how long

it will take to recover their initial cost and to how much efficiently they are utilizing their resources

to create wealth for the owners of company.

However the current packaging process of the company is obsolete and it is expected that if

company spends money to upgrade existing plant it will not be beneficial in the future. Based on

past experiences the company has estimated following figures for the current process if the

management update the existing plant and do not replace it with new Packaging Machine. This up gradation requires initial cost of Rs. 30000, however for next 3 years it is expected to generate

following cash flows from existing machine

Year Cash Flows

1 25000

2 -8500

3 15000

From given information you have to calculate the MIRR for Company ABC by applying

Discounting Approach. This company uses 16% required rate of return to evaluate its projects.

You are also supposed to highlight different MIRR Approaches and why there is need to

calculate MIRR Instead of IRR?

Answer 1

Step 1:

There is no salvage value.

Annual depreciation = Equipment Cost / Useful Life

                                 = Rs.1,000,000 / 5

                                 = Rs. 200,000

Step 2: Calculation of NPV, profitability index and discounted cash flow:

Step 3: Formula used for computing the NPV, profitability index and discounted cash flow:

Step 4: Calculation of MIRR:

Step 5: Formula used for calculating MIRR:

Explanation:

The MIRR is lesser than the required rate of return; therefore, it is not viable to select this option.

There are three ways to calculate MIRR:

1. Discounting approach - As per this approach, all cash outflows are discounted to year 0. For example, in this case, the year 2 cash outflow of -8,500 is discounted to year 0 to find the MIRR.
2. Reinvestment approach - As per this approach, except for year 0 cash outflow, all the years cash flow is discounted using the reinvestment rate, then the discounted cash inflow is divided by the cash flow to determine the MIRR. Formula: MIRR = ((Discounted Cash Inflow / Cash Outflow)^(1/n)) -1. Here, n indicates the number of years.
3. Combination approach - In this case, all the cash outflows are discounted to year 0 using the required rate of return or the discount rate. Next, all the cash inflows value is determined at the end of the project life value using the reinvestment rate. Formula: MIRR = ((Cash Inflows at the end of project / All Cash Outflows)^(1/n)) -1. Here, n indicates the number of years.

In this case, MIRR is used and preferred over IRR because the cash flows are non-conventional. That is, in year 2, there is a cash outflow. When the cash flows are non-conventional, then it will result in multiple IRR. In this case, there will be multiple IRR, which cannot be used for decision making.