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Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937

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Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937
Textbook Problem
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MULTIPLE IRRS AND MIRR A mining company is deciding whether to open a strip mine, which costs $2 million. Cash inflows of $13 million would occur at the end of Year 1. The land must be returned to its natural state at a cost of $12 million, payable at the end of Year 2.

  1. a. Plot the project’s NPV profile.
  2. b. Should the project be accepted if WACC = 10%? if WACC = 20%? Explain your reasoning.
  3. c. Think of some other capital budgeting situations in which negative cash flows during or at the end of the project’s life might lead to multiple IRRs.
  4. d. What is the project’s MIRR at WACC = 10%? At WACC = 20%? Docs MIRR lead to the same accept/reject decision for this project as the NPV method? Does the MIRR method always lead to the same accept/reject decision as NPV? (Hint: Consider mutually exclusive projects that differ in size.)

a.

Summary Introduction

To construct: NPV profile for the given project.

Introduction:

Capital Budgeting:

It refers to the long-term investment decisions that has been taken by the top management of a company and that are irreversible in nature. These decisions require investment of large amount of cash of the company.

Net Present Value (NPV):

It is a method under capital budgeting which includes the computation of the net present value of the project in which company is investing. The calculation is done by calculating the difference between the value of cash inflow and value of cash outflow after taking into consideration the discounted rate.

Explanation

Given information:

An initial investment of the project is $2 million.

Cash inflow at the end of year 1 is $13 million.

Cash outflow at the end of year 2 is $12 million.

Calculation of NPV at 5%, 10%, 15% and 20% WACC is:

Table (1)

NPV profile of the given project is,

b.

Summary Introduction

To explain: Whether the project should be accepted or not at 10% WACC and 20% WACC.

c.

Summary Introduction

To identify: A situation where the negative cash flows during or at the last of the project’s life might lead to multiple internal rate of return.

Introduction:

Internal Rate of Return (IRR):

It refers to the rate of return that is computed by the company to make a decision of selection of a project for investment. This rate provides the basis for selection of projects with a lower cost of capital and rejection of project with a higher cost of capital.

d.

Summary Introduction

To calculate: MIRR of the project at 10% and 20% WACC.

Introduction:

Modified Internal Rate of Return (MIRR):

It refers to the rate of return that is computed by the company to make a decision of selection and ranking of a project for investment. This is a modified version of IRR with reinvestment of cash flows at the cost of capital.

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