Question

Reflex Pte Ltd (“Reflex”) has undertaken market research at a cost of $200,000 in order to evaluate two potential investment projects that have similar capital requirements. Due to limited resources, the company is currently only able to choose one project to execute.
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Timed Online Assignment – January Semester 2020
The cash flow projections are set out below:
Year
0
1
2
3
Project A
(2,000,000)
750,000
1,250,000
1,750,000
Project B
(1,850,000)
(250,000)
1,500,000
2,750,000
Jack is Reflex’s corporate finance manager. He has evaluated that for Project A, the cost of capital should be 10%. As Project B is assessed to be of higher risk than Project A, the cost of capital of 12% was deemed to be more appropriate for Project B.
As Jack is preparing his proposal for recommendation, he receives a call from his boss. His boss questions Jack as to why he is using different discount rates to evaluate the project. Jack’s boss also wants him to include IRR as one of the evaluation criteria. Jack does not think that the IRR method is appropriate but he needs to justify to his boss.
(a) Appraise each project from the perspective of net present value and explain which project you would recommend Reflex to launch first.

(b) Discuss whether Jack can rely on his company’s cost of capital to evaluate all its investment projects.

(c) Explain why Jack does not think it is appropriate to use IRR to evaluate the two projects.

(d) Jack’s boss still insists on using the IRR method. Propose an alternative method to Jack to adjust his IRR calculations in order to address some of his concerns about using IRR to evaluate the two projects.

Answer 1

b. Yes Jack can rely on his company's cost of capital to evaluate all it's investment projects, because cost of capital is the benchmark or the discounting rate to evaluate a project. The company's investment decision for a new project should give a return more than the company's cost of capital which is used to finance the project, only then the project will be accepted because it will then bring return for the investors. If the return is less than the cost of capital, project will not be accepted because it will not bring return for the shareholders.

Therefore, company's cost of capital can be used to evaluate all it's investment decision.

c. Jack does not think it appropriate to use IRR because of the limitations associated with it. The major limitations of IRR is that, multiple solutions could be found out for the same project, and IRR assumes that the positive future cash flows are reinvested at IRR, which gives an over optimistic view.

d. An alternative method to IRR to overcome some issues can be MIRR i.e Modified Internal Rate of Return.

MIRR overcomes the limitations of IRR. MIRR assumes that the firm's positive cash flows are reinvested at the firm's cost of capital and initial outlays are financed at the firm's financing cost. This gives a single value and not multiple values of IRR and is more realistic.

MIRR can be calculated by using the formula: