Cute Camel Woodcraft Company is analyzing a project that requires an initial inv

Question

Cute Camel Woodcraft Company is analyzing a project that requires an initial investment of $600,000. The project's expected cash flows are Year Cash Flow Year 1 $300,000 Year 2 -175,000 Year 3 425,000 Year 4 400,000 Cute Camel woodcraft Company's WACC is 10%, and the project has the same risk as the firm's average project. Calculate this project's modified internal rate of return (MIRR): 17.05% 14.21% 11.37% 15.63% o If Cute Camel Woodcraft Company's managers select projects based on the MIRR criterion, they should this independent project. Which of the following statements best describes the difference between the IRR method and the MIRR method? O The IRR method uses the present value of the initial investment to calcuate the IRR. The MIRR method uses O The IRR method uses only cash inflows to calculate the IRR. The MIRR method uses both cash inflows and O The IRR method assumes that cash flows are reinvested at a rate of return equal to the IRR. The MIRR method the terminal value of the initial investment to calculate the MIRR cash outflows to calculate the MIRR assumes that cash flows are reinvested at a rate of return equal to the cost of capital. Brade It Now Save & Continue Continue without saving

Explanation / Answer

MIRR is the rate at which present value of terminal value of cash inflows is equal to the Present value of cash outflows. The terminal value is the future value (FV) of cash inflows and is computed using WACC as the rate of investment. In simpler words, we are comparing one cash inflow (terminal value) with one cash outflow (Present value of outflows). So, first we need to compute one future value of cash inflows.

FV = Amount x (1 + r)n where r is the WACC and n being the no. of years remaining

Now, Present value of Terminal Value = Present value of cash outflows

or, Terminal Value / (1 + MIRR)4 = $600,000 + [ $175,000 / (1 + 0.10)2 ]

or, $1,266,800 / (1 + MIRR)4 = $600,000 + $144,628.099172

or, (1 + MIRR)4 = 1.70125194228

or, (1 + MIRR) = 1.1420685

or, MIRR = 0.1420685 or 14.21%

They should accept this project as MIRR is more than the WACC.

The IRR method assumes that cash flows are reinvested at a rate of return equal to the IRR. The MIRR method assumes that cash flows are reinvested at a rate of return equal to the cost of capital. (third option)

Terminal Value Year Cash Flows Future value 1 $300,000 $300,000 x (1 + 0.10)3 = $399,300 2 (-)$175,000 - 3 $425,000 $425,000 x (1 + 0.10)1 = $467,500 4 $405,000 $400,000 x (1 + 0.10)0 = $400,000 Terminal Value $1,266,800

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