Capital budgeting criteria A firm with a 14% WACC is evaluating two projects for
ID: 2654922 • Letter: C
Question
Capital budgeting criteria
A firm with a 14% WACC is evaluating two projects for this year's capital budget. After-tax cash flows, including depreciation, are as follows:
Calculate NPV for each project. Round your answers to the nearest cent.
Project A $ {C}
Project B $ {C}
Calculate IRR for each project. Round your answers to two decimal places.
Project A {C}%
Project B {C}%
Calculate MIRR for each project. Round your answers to two decimal places.
Project A {C}%
Project B {C}%
Calculate payback for each project. Round your answers to two decimal places.
Project A {C} years
Project B {C} years
Calculate discounted payback for each project. Round your answers to two decimal places.
Project A {C} years
Project B {C} years
Assuming the projects are independent, which one or ones would you recommend?
-Select-Only Project B would be accepted because NPV(B) > NPV(A).Both projects would be accepted since both of their NPV's are positive.Only Project A would be accepted because IRR(A) > IRR(B).Both projects would be rejected since both of their NPV's are negative.Only Project A would be accepted because NPV(A) > NPV(B).Item 11
If the projects are mutually exclusive, which would you recommend?
-Select-If the projects are mutually exclusive, the project with the highest positive IRR is chosen. Accept Project A.If the projects are mutually exclusive, the project with the highest positive MIRR is chosen. Accept Project A.If the projects are mutually exclusive, the project with the shortest Payback Period is chosen. Accept Project A.If the projects are mutually exclusive, the project with the highest positive IRR is chosen. Accept Project B.If the projects are mutually exclusive, the project with the highest positive NPV is chosen. Accept Project B.Item 12
Notice that the projects have the same cash flow timing pattern. Why is there a conflict between NPV and IRR?
-Select-The conflict between NPV and IRR is due to the relatively high discount rate.The conflict between NPV and IRR is due to the fact that the cash flows are in the form of an annuity.The conflict between NPV and IRR is due to the difference in the timing of the cash flows.There is no conflict between NPV and IRR.The conflict between NPV and IRR occurs due to the difference in the size of the projects.Item 13
Explanation / Answer
(‘1) NPV
NPV= Present Value of Cash Inflow- Initial Investment
WACC= 14 %
Project life = 5 years
AF @ 14 % for 5 year= 3.433
NPV (A)=( 3.433 x 1000)- 3000
NPV (A) = $ 433.08
NPV (B)= (3.433 x 2800)-9000
NPV (B)= $612.63
(‘2) IRR
IRR is the rate of return at which NPV= 0
NPV (A) at 19 % = $57.63
NPV (A) at 20 % = - $ 9.39
Hence IRR will be between 19 % and 20 %.
By using interpolation we get
IRR (A) = 19.86 %
NPV (B) at 16 % = $ 168.02
NPV (B) at 17 % = -$ 41.83
Hence IRR will be between 16 and 17 %.
By using interpolation we get
IRR(B)= 16.80 %
(‘3) MIRR
Year
Project A CF
Project B CF
Reinvestment Duration
Reinvestment rate factor @ 14 % (1.14)Duration
Terminal Value (A)
( CF x Reinvestment Factor)
Terminal Value (B)
( CF x Reinvestment Factor)
1
1000
2800
4
1.689
1688.96
4729.09
2
1000
2800
3
1.482
1481.54
4148.32
3
1000
2800
2
1.300
1299.60
3638.88
4
1000
2800
1
1.140
1140.00
3192.00
5
1000
2800
0
1.00
1000.00
2800.00
6610.10
18,508.29
MIRR = (TV of Cash Flow / PV of Cash Flow)1/n -1
MIRR (A) = (6610.10/ 3000)1/5 -1
MIRR (A) = 17.12 %
MIRR (B)= (18508.29/ 9000)1/5-1
MIRR (B)= 15.51 %
(‘4) Payback Period
Payback Period= Initial Investment / Annual Cash Flow
Payback (A)= $ 3000 / $ 1000
Payback (A)= 3 Years
Payback (B)= $9000/ $2800
Payback (B)= 3.21 Years
(‘5) Discounted Payback Period
Year
CF (A)
CF (B)
DF @ 14 %
DCF (A)
Cum DCF (A)
DCF (B)
DCF (B)
1
1000
2800
0.877
877.19
877.19
2456.14
2456.14
2
1000
2800
0.769
769.47
1646.66
2154.51
4610.65
3
1000
2800
0.675
674.97
2321.63
1889.92
6500.57
4
1000
2800
0.592
592.08
2913.71
1657.82
8158.39
5
1000
2800
0.519
519.37
3433.08
1454.23
9612.63
Initial Investment cost for A = $ 3000
By observing DCF (A) we get that in the 5th year discounted cash flow recovered the initial investment
For $ 519.37 cash flow generation takes 1 year
Hence $ 86.29 cash flow ( 3000-2913.71) will take 0.17 years ( 86.29/519.37)
Discounted payback (A) = 4 + 0.17 = 4.17 years
Similarly discounted payback (B)= 4.58 Years
Decision if Projects are Independent-
If both projects are independent, it means they do not compete to each other , then both projects A and B will be accepted because
Both have positive NPV
Both have IRR and MIRR greater than WACC.
If the projects are mutually exclusive
Mutually exclusive means acceptance of one project will exclude the acceptance of other project.
If both projects are mutually exclusive and NPV and IRR/MIRR reflect the contradictory choice then always NPV criteria should be used. It means projects having higher NPV should be accepted.
In the given case NPV of B is more than NPV of A hence, project B should be accepted.
Reason for conflict between NPV and IRR-
The conflict between NPV and IRR occurs due to difference in size of projects.
Year
Project A CF
Project B CF
Reinvestment Duration
Reinvestment rate factor @ 14 % (1.14)Duration
Terminal Value (A)
( CF x Reinvestment Factor)
Terminal Value (B)
( CF x Reinvestment Factor)
1
1000
2800
4
1.689
1688.96
4729.09
2
1000
2800
3
1.482
1481.54
4148.32
3
1000
2800
2
1.300
1299.60
3638.88
4
1000
2800
1
1.140
1140.00
3192.00
5
1000
2800
0
1.00
1000.00
2800.00
6610.10
18,508.29
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