Question

Use the following information about All I Got (NASDAQ: AIG) to answer questions 18-22.

AIG is evaluating a project that costs $25 million in year 0 and is expected to generate after-tax cash inflows equal to $5 million in year 1, $10 million in year 2, $15 million in year 3, and $20 million in year 4. The firm’s cost of capital is 10 percent.

Assume that the firm is using only regular payback method to make its capital budgeting decision. (a) What is the regular (traditional) payback period? (b) If the target cutoff period is 3 years, should the firm accept the project

Assume that the firm is using only discounted payback method to make its capital budgeting decision. (a) What is the discounted payback period? (b) If the target cutoff period is 3 years, should the project be accepted

Assume that the firm is using only net present value (NPV) to make its capital budgeting decision. (a) What is the NPV? (b) Should the project be accepted?

Assume that the firm is using only internal rate of return (IRR) to make its capital budgeting decision. (a) What is the IRR? (b) Should the project be accepted?

Assume that the firm is using only modified internal rate of return (MIRR) to make its capital budgeting decision. (a) What is the MIRR? (b) Should the project be accepted?

Answer 1

1. payback period=

CF0= -25 CF1= 5, CF2=10, CF3=15, CF4=20

So, cumulative cash flow= CCF0= -25, CCF1= -20, CCF2= -10, CCF3= 5

SO, Payback period= full years until recovery+ ( uncovered cost at begining of lastyear/ cash flow during last year)

= 2+ (5/15) = 2.33 years

if the target cutoff period is 3 years then this venture is profitable as cash flows will be recovered in 2.33 years from this project.i.e. before the cutoff period.

2. discounted payback period=

CF0= -25 CF1= 5, CF2=10, CF3=15, CF4=20

discounted cash flow= -25, 4.545, 8.26, 11.2697, 13.66 respectively

So, cumulative discounted cash flow= CCF0= -25, CCF1= -20.45, CCF2= -12.19, CCF3= -0.925, CCF4= 12.73

SO, Payback period= full years until recovery+ ( uncovered cost at begining of lastyear/ cash flow during last year)

= 3+ (12.73-0.925/13.66) = 3.9319 years

if the target cutoff period is 3 years then this venture is NOT profitable as cash flows will NOT be recovered in 3 years from this project.i.e. before the cutoff period.

3. npv OF THE PROJECT IS CALCULATED AS BELOW

CF0= -25 CF1= 5, CF2=10, CF3=15, CF4=20

discounted cash flow= -25, 4.545, 8.26, 11.2697, 13.66 respectively

SO NET PRESENT VALUE = 12.73

aS NPV IS POSITIVE, THIS PROJECT SHOULD BE ACCEPTED.

4. IRR of the project is 27.27% as IRR is greater than the cost of capital i.e. 10% thus the project is profiatable and should be accepted.