CAPITAL BUDGETING CRITERIA Your division is considering two projects. Its WACC is 10%, and the projects’ after-tax cash flows (in millions of dollars) would be as follows:

1. a. Calculate the projects’ NPVs, IRRs, MIRRs, regular paybacks, and discounted paybacks.
2. b. If the two projects are independent, which project(s) should be chosen?
3. c. If the two projects are mutually exclusive and the WACC is 10%, which project(s) should be chosen?
4. d. Plot NPV profiles for the two projects. Identify the projects’ IRRs on the graph.
5. e. If the WACC was 5%, would this change your recommendation if the projects were mutually exclusive? If the WACC was 15%, would this change your recommendation? Explain your answers.
6. f. The crossover rate is 13.5252%. Explain what this rate is and how it affects the choice between mutually exclusive projects.
7. g. Is it possible for conflicts to exist between the NPV and the IRR when independent projects are being evaluated? Explain your answer.
8. h. Now look at the regular and discounted paybacks. Which project looks better when judged by the paybacks?
9. i. If the payback was the only method a firm used to accept or reject projects, what payback should it choose as the cutoff point, that is, reject projects if their paybacks are not below the chosen cutoff? Is your selected cutoff based on some economic criteria, or is it more or less arbitrary? Are the cutoff criteria equally arbitrary when firms use the NPV and/or the IRR as the criteria? Explain.
10. j. Define the MIRR. What’s the difference between the IRR and the MIRR, and which generally gives a better idea of the rate of return on the investment in a project? Explain.
11. k. Why do most academics and financial executives regard the NPV as being the single best criterion and better than the IRR? Why do companies still calculate IRRs?

To calculate: The NPV, IRR and MIRR payback period and discounted payback period for the given projects.

Introduction:

Capital Budgeting:

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

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.

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.

Payback Period:

It refers to the time period that is required to get an amount invested in a project with some return on it. In other words, it is the time that a project takes to repay the amount invested with some return attached to it.

Discounted Payback Period:

It refers to the time period that a project takes to repay the amount invested with some returns attached to it after taking the time value of money or discounted cash flows.

The NPV, IRR, and MIRR for project A on a spreadsheet,

Table (1)

The NPV, IRR, and MIRR for Project A are $7.73 million, 19.19%, 17.66%, respectively.

The NPV, IRR, and MIRR for Project B on a spreadsheet,

Table (2)

The NPV, IRR, and MIRR for Project B are $6.55 million, 22.52%, 17.79%, respectively.

The formula to calculate payback period is,

Payback Period = (Year of Last NegativeCumulative Cash Flow)+|Last Negative Cumulative Cash flow|(Positive Cash Flowin the Next Year)

Project A

Substitute 2 for the year of last negative cumulative cash flow, −$15 for last negative cumulative cash flow and $15 for positive cash flow in the next year.

Payback Period = (2)+|−$15|($15)=2+1=3

The payback period for the Project A is 3 years.

Working note:

Calculation of cumulative cash flow,

Table (3)

Project B

Substitute 1 for the year of last negative cumulative cash flow, -$10 for last negative cumulative cash flow and $10 for positive cash flow in the next year.

Payback Period = (1)+|−$10|($10)=1+1=2

The payback period of the project B is 2 years.

Working note:

Calculation of cumulative cash flow,

To explain: Whether the Project A or Project B should be accepted if the projects are independent.

To explain: Whether the Project A or Project B should be chosen when they are mutually exclusive.

To construct: NPV profiles of the two projects and their IRR.

To explain: Whether the Project A or Project B should be chosen at 5% and 15% WACC.

To explain: The crossover rate and its effects on the choice between mutually exclusive projects.

Introduction:

Crossover Rate:

It refers to that discounted rate at which the NPV of the two projects becomes equal. It is a cost of capital of the project.

To explain: Whether the conflict exists between NPV and IRR in case of independent projects.

To explain: Whether the Project A or Project B should be chosen on the basis of paybacks period.

To explain: The cutoff criteria of payback period and whether this criterion is arbitrary for payback, NPV and IRR method.

To explain: The MIRR, difference between IRR and MIRR and whether the MIRR or IRR gives a better idea of the rate of return on investment in a project.

To explain: The reason of NPV being a single best criterion for capital budgeting decisions and the reason for companies to calculate IRR.