Berra, Inc. is currently considering two 4-year projects. Because of capital rat

Question

Berra, Inc. is currently considering two 4-year projects. Because of capital rationing (shortage of funds for financing), Berra wants to choose the best project. Cash Flow Initial cost Project R Projects $(25,000)$(30,000) Cash flow year 1 Cash flow year 2 Cash flow year 3 Cash flow year 4 $21,000 $6,000 $ 4,000 $ 3,000 7,000 $ 16,000 $24,000 What is the Modified Internal Rate of Return (MIRR) for each project if the discount If the discount rate was 11%, what would be the NPV for each project and which Besides MIRR and NPV, what are the other four capital budgeting decision models? a) rate is 7%? (3 marks) project should Berra choose? (2 marks) c) (2 marks)

Explanation / Answer

a.

stage 1 : taking the project cashflows from the return phase , compound each cashflows forward to the end of the project using the firm's cost of capital (7%).

FOR PROJECT R

year 1 cash flow compounded at 7% for 3 years ; year 2 cash flow is compounded for 2 years ; year 3 is compounded for 1 year

i.e all values at year 4 = (25725.903 + 6869.4 + 4280 + 3000 )$ = $39875.303

stage 2 : taking the total of the cashflows extended to year 4 , calculate the discount rate required to set this value when discount equal to the outflow . to do this we need to use the following formula :

outflow = terminal cashflow / ( 1+MIRR)^n

( 1+MIRR)^n = terminal cashflow/outflow

1+MIRR = n rootover (terminal cashflow/outflow)

MIRR =[ n rootover (terminal cashflow/outflow)] -1

MIRR = [4 root over ($39875.303 / $25000)] -1

MIRR = [4 root over (1.59501212)] -1

MIRR = 12.38%

FOR PROJECT S

year 1 cash flow compounded at 7% for 3 years ; year 2 cash flow is compounded for 2 years ; year 3 is compounded for 1 year

i.e all values at year 4 = (0+ 8014.3 + 17120 + 24000 )$ = $49134.3

stage 2 : taking the total of the cashflows extended to year 4 , calculate the discount rate required to set this value when discount equal to the outflow . to do this we need to use the following formula :

outflow = terminal cashflow / ( 1+MIRR)^n

( 1+MIRR)^n = terminal cashflow/outflow

1+MIRR = n rootover (terminal cashflow/outflow)

MIRR =[ n rootover (terminal cashflow/outflow)] -1

MIRR = [4 root over ($49134.3 / $30000)] -1

MIRR = [4 root over (1.63781)] -1

MIRR = 13.13%

B.

c. Apart from MIRR and NPV 4 other capital budgeting decision models are -   

  

(1.07)^n YEAR PROJECT R FV FACTOR value at year 4 1 21000 1.225043 25725.903 2 6000 1.1449 6869.4 3 4000 1.07 4280 4 3000 3000 Total = 39875.303

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