A Letter to the CFO, VP Strategic Planning, Regarding Construction Project Financials

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To: CFO, VP Strategic Planning Re: Construction project financials There are a few things I would like to say about the construction project. The project is expected to maximize firm value if it has incremental cash flows above zero. If we are using the modified internal rate of return (MIRR) technique, this means that the MIRR should be above the cost of capital. As we can see from the spreadsheet, the MIRR is 18%. This means that the project is going to return that. The cost of capital should be the rate of return on our existing business. The way we maximize firm value is to undertake projects that offer a better return than our existing business. In this case, there are some issues with the calculation, however. Conducting an MIRR measurement is supposed to be done with incremental cash flows. In this case, depreciation is treated improperly. The only relevance of depreciation as a cash flow is in the tax benefit that it offers, as an income statement expense that reduces our taxable income (Erhardt & Wachowicz, 2006). In the spreadsheet, depreciation is taken as a cash flow. Additionally, the lease expense is $1.5 million per year, but is taken at $300,000 on the spreadsheet. The depreciation error does not affect the end decision, as the MIRR of the project falls to 16%, still above 10% or 15%. However, the lease error does change the project's value significantly. Capital projects can have an impact on the stock's valuation. Bear in mind that the stock

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