Tinker Tools, Inc. is considering a project with the following cash flows. Calculate the MIRR of the project assuming a reinvestment rate of 8%.
Year Cash Flows
0 ($70,000)
1 ($55,000)
2 $40,000
3 $60,000
4 $100,000
Answer:
PV Cash Outflows
Year 0 = -$70,000
Year 1: Calculator Steps' → N=1, i=8, FV=-55,000, solve for PV = -$50,926
PV Outflows = -$70,000 - $50,926 = -$120,926
FV of Cash Inflows
N=2, i=8, PV=40000, PMT =0, solve for FV = $46,656
N=1, i=8, PV=60000, PMT =0, solve for FV = $64,800
FV of Inflows = $46,656 +$64,800 + $100,000 = $211,456
MIRR: N=4, PV=-$120,926,FV= $211,456 solve for i=15%
Determine the IRR on the following projects:
a. Initial outlay of $35,000 with an after-tax cash flow at the end of the year of $5,836 for seven years
b. Initial outlay of $350,000 with an after-tax cash flow at the end of the year of $70,000 for seven years
c. Initial outlay of $3,500 with an after-tax cash flow at the end of the year of $1,500 for three years
Answer:
Using a financial calculator
a. N=7, PV=-35,000, PMT=5,836, FV= 0, solve for i=4.02%
b. N=7, PV=-350,000, PMT=70,000, solve for i=9.2%
c. N=7, PV=-3,500, PMT=1,500, FV= 0, solve for i=13.7%
Discuss the merits and shortcomings of using the payback period for capital budgeting decisions.
Answer: The payback period is intuitive and easily understood even by those with no training in finance. It also provides a quick assessment of a project's risk because cash flow forecasts are likely to be more accurate for the near-term.
On the other hand, there is no clear-cut decision rule associated with this method; it does not specifically take the time value of money into account, and it ignores cash flows that occur after the payback period.
Project November requires an initial investment of $500,000. The present value of operating cash flows is $550,000. Project December requires an initial investment of $750,000. The present value of operating cash flows is $810,000.
a. Compute the profitability index for each project.
b. If the projects are mutually exclusive, does the profitability index rank them correctly?
Answer:
a. The PI for November is 550,000/500,000 = 1.1. The PI for December is 810,000/750,000 = 1.08.
b. The PI criterion would select project November because it has the higher PI. December, however, has the higher NPV ($60,000 v. $50,000) and should be selected, so the method does not rank the projects correctly.
Black Friday Inc. has estimated the following cash flows for a project it is considering:
Period | Cash Flow |
0 | ($150,000) |
1 | $70,000 |
2 | $80,000 |
3 | ($100,0000) |
a. What is the payback period for this project?
b. What is the obvious problem with using the payback method in this case?
Answer: The payback period is exactly 2 years (70,000+80,000) = 150,000. However, the project obviously has a negative NPV at any discount rate. One major problem with the payback method is that it ignores cash flows occurring after the payback period.
