3. Montrose Manufacturing is considering two potential investments. Each project

Question

3. Montrose Manufacturing is considering two potential investments. Each project will cost $70,000 and have an expected life of five
years. The CFO has estimated the probability distributions for each project's cash flows as shown in the following table.

Probability         Potential Cash Flows

                          Project 1                       Project 2
25%                   12,000                          10,000
50%                    27,000                          30,000
25%                   36,000                           46,000

The company believes that the probability distributions apply to each year of the five years of the projects' lives. Montrose Manufacturing
uses the risk-adjusted discount rate technique to evaluate potential investments.
As a guide for assigning the risk premiums, the CFO has put together the following table based on the coefficient of variation.

Coefficient of Variation      Risk Premium
0.00                                  -1.50%
0.20                                    0%
0.30                                     1%
0.40                                    1.50%
0.50                                     2.50%

c. Using the appropriate discount rates, calculate the payback period, discounted payback period, NPV, PI, IRR, and MIRR for each
project.
d. If the projects are mutually exclusive, which should be accepted? What if they are independent?

Explanation / Answer

c

Project 1

Payback period is the time by which undiscounted cashflow cover the intial investment outlay

this is happening between year 2 and 3

there fore payback period = 2 + (-25500*2 +70000)/25500 = 2.745years

Discounted payback period is the time by which discounted cashflow cover the intial investment outlay

this is happening between year 3 and 4

there fore discounted payback period = 3 + (-(22926.84 + 20613.33 + 18533.28) + 70000)/16663.12 = 3.4756 years

NPV = sum of discounted cash flows = 23718.23

PI = (sum of discounted cash flows + initial investment outlay)/ initial investment outlay = 93718.233/70000=1.3388

IRR

MIRR

MIRR = ((Sum of future value of cashflows/initial investment outlay)^(1/life of project) – 1)*100

Compounding factor = (1 + discount rate)^(Life of project – corresponding time of cashflow)

Future value of cashflow = Cash flow value * compounding factor

Project B

Payback period is the time by which undiscounted cashflow cover the intial investment outlay

this is happening between year 2 and 3

there fore payback period = 2 + (-29000*2 +70000)/29000 = 2.413years

Discounted payback period is the time by which discounted cashflow cover the intial investment outlay

this is happening between year 3 and 4

there fore discounted payback period = 3 + (-(25915.53 + 23159.13 + 20695.91) + 70000)/18494.67 = 3.0124 years

NPV = sum of discounted cash flows = 34792.8

PI = (sum of discounted cash flows + initial investment outlay)/ initial investment outlay = 104792.8/70000=1.49704

IRR

d.

Project 2 should be selected incase of mutually exclusive projects as it has greater NPV

In case of independent projects both should be selected as both have NPV > 0

Required rate =   11.223% Year 0 1 2 3 4 5 Cash flow stream -70000 25500 25500 25500 25500 25500 Discounting factor 1 1.112234 1.237063 1.375903 1.530326 1.70208 Discounted cash flows project -70000 22926.84 20613.33 18533.28 16663.12 14981.67 Sum of discounted cashflows = 23718.23 Discounting factor = (1 + Required rate)^(CORRESPONDING PERIOD IN YEARS) Discounted Cashflow= Cash flow stream/discounting factor

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