Question

In: Finance

Discuss the notions of conventional and nonconventional cash flows in capital budgeting. Which investment evaluation criteria...

Discuss the notions of conventional and nonconventional cash flows in capital budgeting. Which investment evaluation criteria would you use for unconventional cash flows and why? Provide a fictitious example and apply the NPV, IRR, and MIRR methods to your example. Interpret the results.

Solutions

Expert Solution

Conventional cash flows are cash flows that have a negative cash flow as the initial cash flows and then a series of positive cash flows that follows it.

For example:

CF0 = $1000

CF1= $500

CF2 = $300

Let us calculate the NPV, IRR for this project.

NPV@ REQUIRED RETURN = 8%

($1000) + 500/1.08 + 300/1.08^2

= ($279.83)

IRR = -14.79

So, as the NPV and IRR is negative, the project should not be accepted.

Non conventional cash flows :

An unconventional cash flow is a series of inward and outward cash flows over time in which there is more than one change in the cash flow direction.

for example:

CF0 = (65,000)

CF1 = 1,49,000

CF2 = ($78,000)

required rate of return is 12%.

The unconventional cash flows generate more than one IRR. It  generates multiple IRR's .So, the decision to choose weather the project should by undertaken is difficult. For example if there are 2 IRR's one is 5 % and the other is 15%, and the hurdle rate is 10%. It might be difficult to select which project to choose. We should choose the MIRR, as the evaluation criteria as it solves the multiple IRR problem.

The unconventional cash flow computation of the MIRR, it assumes that the cash flows are reinvested at the required rate of return.

The cash flow at year 0 is ($65,000)

the cash flow at year 2 is ($78,000)

Let us calculate the PV of cash flows :

($65,000) + ($78,000)/1.12^2

=$65,000 + $62,181.1224

=$127181.1224

The Fv of cash inflows is = $149,500*1.12 = $167,440

Now lets calculate the MIRR as,

$127181.1224 = $167440/(1+k)^2

(1+k)^2 = 1.3165

(1+k)= 1.1474

or k = 14.7409 %

Therefore, the MIRR is 14.7409%.

As the MIRR > REQUIRED RETURN, we should accept this project. sO, THE PROBLEM OF MULTIPLE IRR, IS SOLVED WITH MIRR, WHICH ASSUMES THAT THE CASH FLOWS ARE REINVESTED AT THE REQUIRED RATE OF RETURN.

The NPV at the required rate of return @12% is $5,854.59.


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