ND Inc. is considering Projects S and L, whose cash flows are shown below. These

Question

ND Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO believes the IRR is the best selection criterion, while the CFO advocates other methods. If the decision is made by choosing the project with the higher IRR, how much, if any, value will be forgone, i.e., what's the NPV of the chosen project versus the maximum possible NPV? What is the Payback period and discounted payback period? What is the Profitability index? MIRR? Discuss your results of these methods and make a recommendation on the projects to the CEO? WACC: 7.00% Year 0 1 2 3 4 CFS $1,100 $550 $600 $100 $100 CFL $2,750 $725 $725 $800 $1,400

Explanation / Answer

PROJECT S: Cumulative Cumulative Year Cash flows Cash flows PVIF at 7% PV at 7% PV PVIF at 12% PV at 12% PVIF at 13% PV at 13% 0 -1100 -1100 1.00000 -1100 -1100 1.00000 -1100 1.00000 -1100 1 550 -550 0.93458 514 -586 0.89286 491 0.88496 487 2 600 50 0.87344 524 -62 0.79719 478 0.78315 470 3 100 150 0.81630 82 20 0.71178 71 0.69305 69 4 100 250 0.76290 76 96 0.63552 64 0.61332 61 Payback = 1+550/600 = 1.92 years 96 4 -13 NPV = $96 Discounted payback = 2+62/82 = 2.76 years PI = 1196/1100 = 1.09 IRR = 12+4/17 = 12.24% MIRR: Year Cash flows FVIF at 7% FV at 7% 1 550 1.22504 673.77 2 600 1.14490 686.94 3 100 1.07000 107.00 4 100 1.00000 100.00 1567.71 MIRR = (1567.71/1100)^(1/4)-1 = 9.26% PROJECT L: Cumulative Cumulative Year Cash flows Cash flows PVIF at 7% PV at 7% PV PVIF at 12% PV at 12% PVIF at 11% PV at 11% 0 -2750 -2750 1.00000 -2750 -2750 1.00000 -2750 1.00000 -2750 1 725 -2025 0.93458 678 -2072 0.89286 647 0.90090 653 2 725 -1300 0.87344 633 -1439 0.79719 578 0.81162 588 3 800 -500 0.81630 653 -786 0.71178 569 0.73119 585 4 1400 900 0.76290 1068 282 0.63552 890 0.65873 922 Payback = 3+500/1400 = 3.35 years 282 -66 -1 NPV = $282 Discounted payback = 3+786/1068 = 3.74 years PI = 3032/2750 = 1.10 IRR = 11% MIRR: Year Cash flows FVIF at 7% FV at 7% 1 725 1.22504 888.16 2 725 1.14490 830.05 3 800 1.07000 856.00 4 1400 1.00000 1400.00 3974.21 MIRR = (3974.21/2750)^(1/4)-1 = 9.64% TABULATION OF RESULTS: Project S Project L Payback in years 1.92 3.35 Discounted payback in years 2.76 3.74 NPV [$] 96.00 282.00 PI 1.09 1.10 IRR % 12.24 11.00 MIRR % 9.26 9.64 IF THE DECISION IS BASED ON IRR, PROJECT S WOULD BE CHOSEN AND THE VALUE FOREGONE WOULD BE 282-96 = $196 RECOMMENDATION: Project L with higher NPV is to be implemented, if sufficient funds are available for investment. Its PI and MIRR are also higher. Where there is conflict in ranking, IRR should not be used; modified IRR can be used, which in this case confirms recommends Project L. However, Project L has higher Payback, the acceptibiity should be left to the mangement.

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