As a separate project (Project P), the firm is considering sponsoring a pavilion
ID: 2664946 • Letter: A
Question
As a separate project (Project P), the firm is considering sponsoring a pavilion at the upcorming World's Fair. The pavilion would cost $800,000, and it is expected to result in $5million of incremental cash inflows during its 1 year of operation. However, it would then then take another year, and $5 million costs, to demolish the site and return it to tis original condition. Thus, Project P's expected net cash flows look like this(in millions of dollars):
0 1 2
- $ 0.8 $5.0 -$5.0
The project is estimated to be of average risk, so its WACC is 10%.
(1) What is Project P's NPV ? What is its IRR ? its MIRR ?
(2) Draw Project P's NPV profile. Does Project P have normal or nonnormal cash flows ? Should this project be accepted ? Explain.
Explanation / Answer
1.)
Calculating Net Present Value
years
A
0
(-$800,000)
1
(-$800,000)
1
$5,000,000
0.909
$4,545,000
2
(-$5,000,000)
0.826
(-$4,130,000)
Net Present Value
(-$385,000)
Calculating Internal Rate of Return (IRR)
using excel
Year
Cash flows
0
(-$800,000)
1
$5,000,000
IRR = 25%
2
(-$5,000,000)
The MIRR of Project P = 5.6%, and is found by
Calculating the discount rate that equates the terminal
Value ($5.5 million) to the present value of costs ($4.93 million)
2.)
You could put the cash flows in your calculator and then enter a series of I/YR values, get an NPV for each, and then plot the points to construct the NPV profile. We used a spreadsheet model to automate the process and then to draw the profile. Note that the profile crosses the X-axis twice, at 25% and at 400%, signifying two IRRs. Which IRR is correct? In one sense, they both are—both cause the project’s NPV to equal zero. However, in another sense, both are wrong—neither has any economic or financial significance. Project P has non normal cash flows; that is, it has more than one change of signs in the cash flows. Without this non normal cash flow pattern, we would not have the multiple IRRs. Since Project P’s NPV is negative, the project should be rejected, even though both IRRs (25% and 400%) are greater than the project’s 10% WACC. The MIRR of 5.6% also supports the decision that the project should be rejected.
Calculating Net Present Value
years
A
0
(-$800,000)
1
(-$800,000)
1
$5,000,000
0.909
$4,545,000
2
(-$5,000,000)
0.826
(-$4,130,000)
Net Present Value
(-$385,000)
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