2) The following data is given for 2 projects that Dog Voices is considering. Pr

Question

2) The following data is given for 2 projects that Dog Voices is considering. Project ($11,000) 6 years $4,000 15% $4,138 28.16% $35,014.95 17 77% 3.82 ($17,000) 6 years $6,000 15% $5,707 26.80% $39,391.82 17.18% 3.96 Initial Investment Duration of Project Cash flow per year Required Rate of Return NPV IRR Terminal value MIRR Discounted Payback If these projects are mutually exclusive, explain which one would you pick. First you must explain the method you would use. a) b) Discuss the relative Advantages and disadvantages of all the methods. c) What can you deduce about the reinvestment rate vs. the finance rate from the MIRR? Is the reinvest rate higher or lower than the finance rate? Explain. d) If these projects are independent, explain which one(s) would you pick (you could pick both).

Explanation / Answer

a) NPV is the sum of present values of all cash flows discounted at an appropriate discount rate or the cost of capital. The present value is calculated as of year 0. IRR is the rate of return at which NPV is zero. When NPV and IRR are in conflict it is better to use NPV because positive NPV increases the value of firm. Here NPV and IRR are in conflict as project A has a higher IRR while project B has a higher NPV. Hence for a mutually exclusive project, choose NPV.

Advantage of NPV:
It gives increase in firms value.
It provides a non conflicting approach to measure an increase in firms value
It can be used for projects with different durations.
Disadvantages are:
The rate is hard to determine as different projects have differing risk
Calculations can be dependent on cost of capital which is dynamic.

IRR advantages:
Gives a single point rate to ascertain the return
easy to compare two projects on a single rate
Also provides single point estimate for differing project lengths
Disadvantages:
There can be more than one IRR
Does not provide the magnitude of increase in firms value
IRR calculation doesn’t account for the reinvestment of interim cash flows

MIRR assumes positive cash flows are reinvested at firms cost of capital where as IRR assumes cash flows are invested at IRR
Addvantages: It does with reinvestment problem of cash flows in IRR.
Disadvantages- these assumptions may be hard to calculate

c) MIRR assumes positive cash flows are reinvested at firms cost of capital where as IRR assumes cash flows are invested at IRR. Thus it solves a problem inherent in IRR
MIRR= [(FV of Cash flows at cost of capital/PV of initial outlays at financing cost)^1/n]-1

Reinvestment rate hence is the prevailing rate at which cash inflows are reinvested while financing rate is the cost of capital. Reinvestment rate would be higher than financing rate for a feasable IRR. If this reinvestment rate is too high to be feasible, then the IRR of the project will fall. If the reinvestment rate is higher than the IRR's rate of return, then the IRR of the project is feasible. Hence for a feasable IRR and MIRR reinvestment rate shall be larger than cost of capital.

d) If the project were independent one would choose both the projects as both are profitable and have IRR as well a MIRR greater than cost of capital

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