Question

Colby Firestone Corporation is considering the purchase of a new machine to replace an old machine. The new machine will cost $135,000, has an installation cost of $5000, and will have an expected life of five years with a salvage value of $5,000. The new machine will require $2000 additional working capital. The new machine will result in a cost savings of $20,000 a year. Sales are expected to increase $9,000 per year. The old machine was purchased five years ago at a cost of $100,000 and has been depreciated on a (McSlim) straight-line basis with an expected life of ten years and a salvage value of $2000. The old machine can be sold for $50,000 today. The firm’s cost of capital is 9 percent, and its tax rate is 30 percent.

1. Modified Internal Rate of Return---Compute the Modified Internal Rate of Return. What does the Modified Internal Rate of Return tell us?
2. Should Colby Firestone Corporation purchase the new machine? Why or why not?
3. What is the reinvestment rate assumption for IRR? What is the reinvestment rate assumption for MIRR? Which do you think is a better assumption? Why?
4. What is Depreciation in accounting and capital budgeting? Depreciation is an expense method.
5. What is McSlim? What does each letter mean?

Answer 1

(a)

Modified Internal Rate of Return assumes that positive cash flows are reinvested at the firm's cost of capital and that the initial outlays are financed at the firm's financing cost. The MIRR, therefore, more accurately reflects the cost and profitability of a project. In this context, calculations can be shown in the table: -

In this case,

The present value of future positive cash flows (in $): -

Henceforth, modified internal rate of return is 11.03%: -

(b)

Yes, the new machine should be purchased because Modified internal rate of return is more than the cost of capital. Hence, it is profitable.

(c)

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

(d)

The MIRR, therefore, more accurately reflects the cost and profitability of a project. The assumption that positive cash flows are reinvested at the IRR is considered impractical in practice. Also, MIRR is designed to generate one solution, eliminating the issue of multiple IRRs. Moreover, MIRR allows project managers to change the assumed rate of reinvested growth from stage to stage in a project.