CAPITAL BUDGETING CRITERIA A firm with a 14% WACC is evaluating two projects for this year’s capital budget. After-tax cash flows, including depredation, are as follows:

1. a. Calculate NPV, IRR, MIRR, payback, and discounted payback for each project.
2. b. Assuming the projects are independent, which one(s) would you recommend?
3. c. If the projects are mutually exclusive, which would you recommend?
4. d. Notice that the projects have the same cash flow timing pattern. Why is there a conflict between NPV and IRR?

To calculate: NPV, IRR, MIRR, payback period and discounted payback period for given projects at 14% WACC.

Introduction:

Capital Budgeting:

Capital budgeting signifies 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):

Net Present Value is a method under capital budgeting, which includes the calculation of net present value of the project in which company is investing. The calculation is done by calculating the difference between the cash inflow and cash outflow value after considering the discount rate.

Internal Rate of Return (IRR):

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

Modified Internal Rate of Return (MIRR):

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

Payback Period:

Payback period signifies to the time period that is required to get back 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:

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

The calculation for NPV, IRR and MIRR of project M in spreadsheet is:

Table (1)

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)

Substitute 2year for year of last negative cumulative cash flow, −$10,000 for last negative cumulative cash flow and $10,000 for positive cash flow in the next year in the above formula to calculate payback period for project M.

Payback Period = (2 years)+|−$10,000|($10,000)=2−1=1 year

The formula to calculate the discounted payback period is,

(Dicounted Payback Period)=(Year of Last Negative Cumulative Present Value)+|Last Negative Cumulative Present Value|(Positive Present Value in the Next Year)

Substitute 4 for year of last negative cumulative present value, −$862.88 for last negative cumulative present value and $5,193.69 for positive present value in the next year in the above formula to calculate discounted payback period for project M:

(Dicounted Payback Period)=(4)+|−$862.88|(5,193.69)=4+0.166=4.166

The NPV is $4,330.81, IRR is 19.86%, MIRR is 17.12%, payback period is 1 year, and discounted payback period is 4.166 years for project M.

The calculation for NPV, IRR and MIRR of project Nin spreadsheet is:

To explain: Whether to choose Project M or Project N when they are independent.

Introduction:

Independent Projects:

Independent projects refer to those projects, whose acceptance or rejection does not have any effect on the decisions regarding acceptance or rejection of any other project. In case of independent projects, two projects can be accepted simultaneously

To explain: Whether to choose project M or project N when they are mutually exclusive.

Introduction:

Mutually Exclusive Projects:

Mutually Exclusive Projects refers to the group of projects in which if one project is accepted it will automatically imply the rejection of rest. It refers to those projects for which investment cannot be made together.

To explain: The reason of conflict between the NPV and IRR.