1.) Suppose you are running a capital budgeting analysis on a project with an es
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Question
1.) Suppose you are running a capital budgeting analysis on a project with an estimated cost of $2 million. The project is considered similar to the existing lines of businesses for the company. Given the cash situation, the company will fund the project completely with a new debt of $2 million. This new debt will be issued at 6% interest for 10 years. The company has an estimated 8% WACC. When conducting the capital analysis on this project, what should be your discount rate (cost of capital) for the project?
2.) Suppose you are managing a two-story rental building in uptown Columbus, GA. You have a tenant in the first story with $3,000 monthly rent. Current the monthly maintenance of the building costs $1,200/month, and you are paying $1,600 monthly mortgage payment including insurance and taxes. You are considering a lease on the second floor, but with another tenant you expect the maintenance costs to increase to $1,500/month, in addition to a $5,000 initial investments to fix up the second floor. Given this information, what are the relevant cash flows that you must factor in to come up with a minimum rent that you must charge. You do not need to compute the rent amount, but must identify the relevant cash flows and the rationale.
3.) In capital budgeting, the IRR implicitly assumes reinvestments of interim cash flows at the IRR itself. First, discuss why this assumption is problematic. Then, explain how MIRR address this issue by presenting your own unique example with proper calcuations. The example project should be a 4 year project. For example, a 4-year project with following cash flows, -500, 200, 200, 200, 100, at T=0 to 4, respectively.
Explanation / Answer
1. The discount rate represents the opportunity costs of investment. The discount rate represents the rate of return that we expect from any other project with similar risk. The WACC better represensts the opportunity cost of investment in case of capital budgeting decisions. Hence the WACC of 8% should be used as discount rate.
2. The relevant cash flows are the monthly maintenance costs and the initial investment of fixing up the second floor. All these cash flows are incremental and they arise from the decision of renting out the 2nd floor. These cash flows must be considered for deciding whether the second floor must be lent out or not.
The monthly mortgage of $1600 is not relevant as this amount will be incurred even if the 2nd floor is not lent out.
3. The assumption is problematic as there is a difference between the short term interest rates and long term interest rates. IRR ignores this difference.
MIRR removes this problem by assuming that re-investments are done at cost of capital and not IRR.
IRR of the above:
IRR = 1.0898-1 = 0.0898 or 8.98%
MIRR: PV of costs = -500. Assume cost of capital = 10%
Terminal value of cash inflows = 200(1.1)^3+200(1.1)^2+200(1.1) = 728.2
MIRR: 500 = 728.2/(1+MIRR)^4
or MIRR = 0.098 = 9.8%
Year Cash flow Discount factor PV 0 -500 1.089876942 -500 1 200 183.507 2 200 168.374 3 100 77.24451 4 100 70.87452 NPV -3.5E-07Related Questions
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