Assignment 11 - Unit 9 Exercise PDF

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Assignment 11 - Unit 9 Exercises...

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Name: Quynh Nguyen-ID: 2020010085 Assignment – 11 – Unit 9 Exercise Please submit in Moodle. No late submission. Please see announcement for last date and time for submission. 1. Consider an investment that costs $100,000 and has a cash inflow of $25,000 every year for 5 years. The required return is 9% and required payback is 4 years. a. What is the payback period? The payback period = Initial outlay/ Cash flow per year = $100,000/ $25,000 = 4 years b. What is the NPV? The NPV = Present value of cash flows – Present value of cash flows (initial investment) NPV = $25,000/ (1.09) + $25,000/ (1.09)^2 + $25,000/ (1.09)^3 + $25,000/ (1.09)^4 + $25,000/ (1.09)^5 - $100,000  The NPV = -$2,758.72 c. What is the IRR?

 The IRR is 7.93% d. Should we accept the project? We should not accept the project as the IRR is less than the required return rate (7.93% < 9%), and it also generates a negative net present value. 2. What decision rules should be the primary decision method? Give reasons and show how they are calculated. The decision rule that should be the primary decision method is the net present value. The reason is that the net present value is a direct measure of how well the project will meet the goal. The NPV assumes that cash flows are reinvested at cost of capital whereas IRR assumes that cash flows are reinvested at IRR rate which is not a fair assumption. If it is a positive NPV,

it means that the project is expected to add value to the firm and it will increase the wealth of the owners. For unconventional cash flows, there are multiple IRR possible, but there will be only one NPV. To calculate the NPV:  The first step is to estimate the expected future cash flows  The second step is to estimate the required return for projects of this risk level  The third step is to find the present value of the cash flows and subtract the initial investment The IRR is also considered as primary decision method when the projects have conventional cash flows (but the NPV is still preferred decision criterion). Generally, it leads to the same answers as the NPV method. If the IRR is high enough, we may not need to estimate a required return. There are two ways to calculate the IRR: financial calculator and the Excel function. Using the financial calculator:  Enter the cash flows and the initial investment as we do with the NPV  Press IRR and then CPT, it will show the result of the IRR Using the Excel function:  First enter the range of the cash flows, beginning with the initial cash flow  Enter a guess result (if necessary)  The default format is a whole percent (keep the result at least two decimals) 3. When is the IRR rule unreliable? What is MIRR and what are three methods of MIRR. Give examples of each method. The IRR is unreliable when the projects have unconventional cash flows (positive and negative cash flows in the following years) with mutually exclusive projects. The MIRR is used on projects with non-conventional cash flows. There are three methods of MIRR:  The discounting approach  The reinvestment approach  The combination approach Example: The project has initial capital outlay of $90,000 and a finance rate of 15%. The cash flow in year one is $132,000; the cash flow in year two is $100,000 and in year three is -$150,000. The discounting approach:

By using the discounting approach method, the cash flow in year three would be discounted back to year 0 at 15%. The adjusted cash flows would be: Year 0: -$90,000 - $150,000/ ((1.15)^3) = -$188,627.43 Year 1: $132,000 Year 2: $100,000 Year 3: $0 MIRR using in this method is 15.77% The reinvestment approach: All the cash flows (positive and negative) except the first are compounded out to the end of the project’s life and then the IRR is calculated. The adjusted cash flows using this method would be: Year 0: -$90,000 Year 1: $0 Year 2: $0 Year 3: -$150,000+$100,000*(1.15) + $132,000*(1.15)^2 MIRR using this method is 15.75% The combination approach: All negative cash flows are discounted back to the present and all the positive cash flows are compounded out to the end of the project’s life. The adjusted cash flows using this method would be: Year 0: -$90,000 - $150,000/ ((1.15)^3) = -$188,627.43 Year 1: 0 Year 2: 0 Year 3: $100,000*(1.15) + $132,000*(1.15)^2 = $289,570 MIRR using this method is 15.36%...