Question

ou are on the staff of Camden Inc. The CFO believes project acceptance should be based on the NPV, but Steve Camden, the president, insists that no project should be accepted unless its IRR exceeds the project’s risk-adjusted WACC. Now you must make a recommendation on a project that has a cost of $15,000 and two cash flows: $110,000 at the end of Year 1 and -$100,000 at the end of Year 2. The president and the CFO both agree that the appropriate WACC for this project is 10%. At 10%, the NPV is $2,355.37, but you find two IRRs, one at 6.33% and one at 527%, and a MIRR of 11.32%. Which of the following statements best describes your optimal recommendation, i.e., the analysis and recommendation that is best for the company and least likely to get you in trouble with either the CFO or the president?

A. You should recommend that the project be rejected because its NPV is negative and its IRR is less than the WACC.

B. You should recommend that the project be rejected because, although its NPV is positive, it has an IRR that is less than the WACC.

C. You should recommend that the project be accepted because (1) its NPV is positive and (2) although it has two IRRs, in this case it would be better to focus on the MIRR, which exceeds the WACC. You should explain this to the president and tell him that that the firm’s value will increase if the project is accepted.

D. You should recommend that the project be rejected because (1) its NPV is positive and (2) it has two IRRs, one of which is less than the WACC, which indicates that the firm’s value will decline if the project is accepted.

Answer 1

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Answer:

Option C

You should recommend that the project be accepted because (1) its NPV is positive and (2) although it has two IRRs, in this case it would be better to focus on the MIRR, which exceeds the WACC. You should explain this to the president and tell him that that the firm's value will increase if the project is accepted.

The modified rate of return is similar to the internal rate of return metric (IRR). The MIRR is a more precise number compared to the IRR metric because the calculation for the MIRR assumes that the project cash inflows are reinvested in the firms cost of capital and the projects cash outflows are financed at the firms financing cost. This is different to the assumption of the IRR calculation where it assumes the that cash flows are reinvested at the IRR rate itself.

The advantage of the MIRR over IRR are:

1) it more accurately takes into account the cost and profitability of the project

2) it is designed in such a way that it only has one solution (as opposed to the IRR where there is a possibility of multiple IRRs)

Also the NPV is positive which means we can recommend the project