T he capital budgeting director of Nulook Cosmetics is evaluating a project whic

Question

The capital budgeting director of Nulook Cosmetics is evaluating a project which costs $200,000, is expected to last for 10 years and produce after-tax operating cash flows of $44,000 per year. Nulook finances internally using only retained earnings and it uses the Capital Asset Pricing Model (CAPM) to determine its cost of capital. Currently, the risk-free rate is 7 percent and the estimated market risk premium is 6 percent. Nulook’s historical beta is 1.5 and its marginal tax rate is 40 percent. Nulook’s director is uncomfortable with the Internal Rate of return (IRR) reinvestment assumption and prefers the modified IRR (MIRR) approach to capital budgeting. What is the project’s MIRR? Should the director accept the project according to the MIRR criterion? Why or why not?

Explanation / Answer

Cost of capital = 7% + 1.5*6% = 16%

Present value of future cash flows = 44000/1.16 + 44000/1.16^2 + 44000/1.16^3 ............44000/1.16^10 = 2,12,662.01

Future value of future cash flows =2,12,662.01*1.16^10 =938144.65

MIRR = (938144.65/200000)^(1/10) -1 =16.71%

MIRR is greater than cost of capital and hence the project should be accepted

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