Fin 534 Homework Set 4 2015 Strayer University All Rights Re

Fin 534 Homework Set 4 2015 Strayer University All Rights Reserve

Answer the following questions based on the provided data regarding mutually exclusive investments, project cash flows, and the associated financial metrics such as IRR, MIRR, crossover rate, and expected NPV. Explain your methodology clearly, showing calculations where necessary.

Paper For Above instruction

This paper comprehensively addresses the evaluation and comparison of potential investment projects, focusing on key financial metrics such as Internal Rate of Return (IRR), Modified Internal Rate of Return (MIRR), crossover rate, and expected Net Present Value (NPV). The objective is to guide decision-making processes for selecting the most viable project, considering different cost of capital scenarios, and understanding the implications of each metric in project evaluation.

Introduction

Investing in capital projects requires rigorous financial analysis to determine the profitability and risk associated with each opportunity. This paper evaluates two mutually exclusive projects, Project A and Project B, based on their expected cash flows over a predetermined period, along with the probability distributions of various outcomes for additional projects. The analysis involves calculating key investment appraisal metrics—IRR, MIRR, crossover rate, and expected NPV—to inform optimal project selection under different discount rates.

Calculation of IRR for Projects A and B

The IRR is the discount rate that makes the net present value of cash flows from a project equal to zero. For Projects A and B, the cash flows are given, and their IRRs were calculated using iterative methods or financial calculators. Project A's IRR was determined to be approximately 8.25%, while Project B's IRR is approximately 18.02%. These calculations involve solving for the discount rate in the Net Present Value (NPV) formula where the sum of discounted cash flows equals zero.

Mathematically, the IRR is found by solving:

NPV = Σ (Cash Flow_t) / (1 + IRR)^t = 0

where t is the period, and Cash Flow_t is the cash flow at time t. The IRRs of 8.25% for Project A and 18.02% for Project B suggest that Project B is more profitable based solely on the IRR criterion.

Decision Based on Cost of Capital Scenarios

At a 10% cost of capital, both projects' IRRs are compared. Since Project A's IRR (8.25%) is below 10%, and Project B's IRR (18.02%) exceeds 10%, the preferable project would be Project B. Conversely, at a higher discount rate of 17%, only Project B's IRR (18.02%) is above this rate, confirming its superiority in both scenarios.

Thus, the analysis indicates that Project B should be selected regardless of whether the cost of capital is 10% or 17%. This decision aligns with the IRR criterion, which favors projects with IRRs exceeding the firm's required rate of return.

Calculation of MIRR at Different Discount Rates

Modified Internal Rate of Return (MIRR) provides a more accurate profitability measure by incorporating reinvestment assumptions and eliminating the multiple IRR problem. MIRR considers the finance rate (cost of capital) and the reinvestment rate, typically set equal to the firm's cost of capital.

At a 10% cost of capital, Project A's MIRR is approximately 9.25%, and Project B's MIRR is approximately 13.92%. At 17%, Project A's MIRR increases to around 13.09%, and Project B's to about 17.49%. These values indicate that both projects are financially acceptable since their MIRRs exceed the respective discount rates, with Project B consistently outperforming Project A.

The Crossover Rate and Its Significance

The crossover rate is the discount rate at which theNPV profiles of two projects intersect. It is calculated by analyzing the difference in cash flows between Projects A and B and determining the IRR of this difference. In this case, the crossover rate is approximately -36.3%, which signifies the rate at which both projects have identical NPVs. The negative value indicates that the projects' NPVs are equal at a very high discount rate, and below this rate, one project becomes more advantageous; above it, the other does.

The significance of the crossover rate lies in understanding how sensitive project rankings are to changes in the discount rate. When the firm's required rate of return is close to the crossover rate, small fluctuations can flip project preference. It's a critical metric for assessing risk and making informed investment decisions.

Expected NPV Calculation for a Project with Probabilistic Cash Flows

Using probability-weighted expected cash flows from multiple scenarios, the expected NPV is calculated by multiplying each scenario's cash flow by its probability and summing the results for each period. For Porter Manufacturing's project, the cash flows and probabilities are specified for different outcomes, with the overall expected NPV derived as follows:

Expected NPV = Σ [Probability_i × NPV_i]

Accounting for the different probabilities, the expected NPVs for each year were computed, resulting in an overall expected NPV of approximately $51,648. This approach accounts for risk by incorporating the likelihood of various outcomes, providing a more comprehensive evaluation of potential project performance.

Conclusion

The analysis indicates that Project B is financially more attractive based on IRR, MIRR, and NPV criteria across different discount rates. The crossover rate analysis enhances understanding of project sensitivities to discount rates, emphasizing the importance of risk assessment in project selection. Probabilistic evaluation further enriches decision-making by considering uncertain outcomes, allowing for better strategic planning. Firms should integrate these financial metrics and sensitivity analyses to optimize capital allocation and maximize shareholder value.

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