Celestial Crane Cosmetics is analyzing a project that requires an initial invest

Question

Celestial Crane Cosmetics is analyzing a project that requires an initial investment of $600,000. The project's expected cash flows are: Year Cash Flo Year $275,000 Year 2 -150,000 Year 3 475,000 Year 4425,000 Celestial Crane Cosmetics's WACC is 7%, and the project has the same risk as the firm's average project. Calculate this project's modified internal rate of return (MIRR) ? 13.33% ? 15.55% O 16.29% O 14.81% If Celestial Crane Cosmetics's managers select projects based on the MIRR criterion, they should independent project. IS Which of the following statements best describes the difference between the IRR method and the MIRR method? O The IRR method uses only cash inflows to calculate the IRR. The MIRR method uses both cash inflows and cash outflows to calculate the MIRR. 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 The IRR method uses the present value of the initial investment to calculate the IRR. The MIRR method uses the terminal value of the initial investment to calculate the MIRR.

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 + [ $150,000 / (1 + 0.07)2 ]

or, $1,270,136.825 / (1 + MIRR)4 = $600,000 + $131,015.80924

or, (1 + MIRR)4 = 1.73749569974

or, (1 + MIRR) = 1.14810321899

or, MIRR = 0.1481032 or 14.81%

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. (second option)

Terminal Value Year Cash Flows Future value 1 $275,000 $275,000 x (1 + 0.07)3 = $336,886.825 2 (-)$150,000 - (only cash inflows) 3 $475,000 $475,000 x (1 + 0.07)1 = $508,250 4 $425,000 $425,000 x (1 + 0.07)0 = $425,000 Terminal Value $1,270,136.825

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