East West University

Assignment on:
Self-Test Problem No. 02

Prepared for:
Dr. Sujit R. Saha
Sub: Financial Management
Code: Fin-501 Sec: 01

Prepared by:
Syed Sadaf Alam
ID: 2018-3-95-018

Submission Date:
9-5-2020
Problem Self-Test 02
Q. You are a financial analyst for Damon Electronics Company. The director of capital
budgeting has asked you to analyze two proposed capital investments, Projects X and Y.
Each project has a cost of $10,000, and the required rate of return for each project is 12
percent. The projects expected net cash flows are as follows:
Expected Net Cash Flows
Year Project X Project Y
0 $(10,000) $(10,000)
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500

a. Calculate each project's traditional payback period (PB), net present value (NPV),
internal rate of return (IRR), modified internal rate of return (MIRR), and discounted
payback period (DPB).
b. Which project or projects should be accepted if they are independent?
c. Which project should be accepted if they are mutually exclusive?
d. How might a change in the required rate of return produce a conflict between the NPV
and IRR rankings of these two projects? Would this conflict exist if r were 5 percent?
(Hint: Plot the NPV profiles.)
e. Why does the conflict exist?
ST-2

a. Payback to determine the payback, construct the cumulative cash flows for project:
Project X Project Y
Year Cash Flows Cumulative CF Cash Flows Cumulative CF
0 $(10,000) $(10,000) $(10,000) $(10,000)
1 6,500 (3,500) 3,500 (6,500)
2 3,000 (500) 3,500 (3,000)
3 3,000 2,500 3,500 500
4 1,000 3,500 3,500 4,000

$ 500
Payback X = 2+ = 2.17 years
$ 3,000
$ 3,000
Payback Y = 2+ = 2.86 years
$ 3,500
Net present value (NPV):
$ 6,500 $ 3,000 $ 3,000 $ 1,000
NPV X = -$10,000 + 1 + 2 + 3 + 4
(1.12) (1.12) (1.12) (1.12)
= -$10,000 + $5,803.57 + $2,391.58 + $2,135.34 + $635.52
= $966.02

$ 3,500 $ 3,500 $ 3,500 $ 3,500

NPV Y = -$10,000 + + + +
(1.12)1 (1.12)2 (1.12)3 (1.12)4
= -$10,000 + $3,125.00 + $2,790.18 + $2,491.23 + $2,224.31
= $630.72

Alternatively, using a financial calculator, input the cash flows into the cash flow register,
I = 12, NPV X = $966.02 and NVP Y = $630.72

Internal Rate of Return (IRR):

Though NPV = 0
IRR X = 18.0%
IRR Y = 15.0%
Modified Internal Rate of Return (MIRR):
TV
PV of cash flows = n
(1+ MIRR)
n
n
∑ CIFt ( 1+r )
Cost = t=1

( 1+ MIRR )n

$ 6,500 (1.12)3 + $ 3,000(1.12)2+ $ 3,000(1.12)1+ $ 1,000( 1.12)0

$10,000 = ¿ ¿
(1+ MIRR X )4
$ 17,255.23
$10,000 =
(1+ MIRR X)4
$ 17,255.23
(1+ MIRR X)^4 = = 1.725523
$ 10,000

MIRR X = (1.725523)1/ 4 – 1.0

= .1481 = 14.81%

$ 3,500 (1.12)3 + $ 3,500(1.12)2 + $ 3,500(1.12)1+ $ 3500( 1.12)0

$10,000 = ¿ ¿
(1+ MIRR Y ) 4
$ 16,727.65
$10,000 = 4
(1+ MIRR Y )
$ 16,727.65
(1+ MIRR Y)^4 = = 1.672765
$ 10,000

MIRR X = (1.672765)1/ 4 – 1.0

= .1373 = 13.73%

Discount Pay Back Period (PB) dis:

Project X Project Y
Year PV CF @ 12% Cumulative CF PV CF @ 12% Cumulative CF
0 $(10,000.00) $(10,000.00) $(10,000.00) $(10,000.00)
1 5.803.57 (4,196.43) 3,125.00 (6,875.00)
2 2,391.58 (1,804.85) 2,790.18 (4,084.82)
 3 2,135.34 330.49 2,491.23 (1,593.59)
4 635.52 966.01 2,224.31 630.72

$ 1,804.85
PB disc X = 2 + = 2.85 years
$ 2,135.34
$ 1,593.59
PB disc Y = 3 + = 3.72 years
$ 2,224.31
b. Summarizes the project rankings by each method:
Project that Ranks Higher
Traditional Payback X
NPV X
IRR X
MIRR X
PB disc X

c. In this case, we would choose the project with the higher NPV @ r = 12% or Project X.

d. To determine the effects of changing the cost of capital, plot the NVP profit of each
project. The crossover rate occurs at about 6 percent (6.2%)
If the firm’s required rate of return is less than 6%, a conflict exist because NPV Y NPV X, but
IRR Y IRR X. Therefore, if r were 5%, a conflict would exist.

NPV Profile
5000

4000 4000
3500
3000
2705
2545
2000
NPV $

1707
1592
1000 966
631
307
0 0 4 8 12 16 518 20
1 2 3 4 5 -206 6 7 -285
-585
-1000 -939

-2000
Required Rate of Return NPV X NPV Y
0% $3,500 $4,000
4 2,545 2,705
8 1,707 1,592
12 966 631
16 307 (206)
18 5 (585)
20 (281) (939)

e. The basic cause of the conflict is differing reinvestment rate assumptions between NVP
and IRR. NVP assumes that cash flows can be reinvested at the cost of the firm users,
whereas IRR assumes reinvestment at the (generally) higher than IRR. The high
reinvestment rate assumption under IRR makes early cash flows especially valuable, and
hence short-term projects look better under IRR.