Chapter 9, Problem 15PROB

Summary Introduction

Net present value:

Net present value is the difference between the present values of cash inflows minus present value of cash outflows.

Calculate the cost of retained earnings are as follows:

$\text{Net present value}=\text{Present value of cash inflows}-\text{Initial investment}$

Decision rule:

$\begin{array}{l}\text{NPV}>\text{0 Accept the project}\\ \text{NPV}<\text{0 Reject the project}\end{array}$

IRR:

IRR is also called as internal rate of return. That is the rate at which present value of cash inflows will be equal to present value of cash outflows. At IRR, NPV will be equal 0.

Decision for IRR rule:

$\begin{array}{c}\text{IRR>Cost of capital, Accept the project}\\ \text{IRR<Cost of capital, Reject the project}\end{array}$

MIRR:

MIRR is also called as modified internal rate of return. Under MIRR cash flows are reinvested at cost of capital. IRR assumes cash flows are reinvested at IRR, which is unrealistic, this was mitigated by the MIRR.

Calculate the MIRR as follows:

$\text{MIRR}=\sqrt[\text{n}]{\frac{\text{Future value of cash flows}}{\text{Present value of cash flows}}}-1$

Decision for MIRR rule:

$\begin{array}{c}\text{MIRR>Cost of capital, Accept the project}\\ \text{MIRR<Cost of capital, Reject the project}\end{array}$

Cost of the project is $365,000 and cash inflows are $260,000 in year 1 and $175,000 in year 2. Cost of capital is 13%.