Intermediate cash inflows cash inflows received prior

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Unformatted text preview: ing of cash flows. intermediate cash inflows Cash inflows received prior to the termination of a project. Ranking is an important consideration when projects are mutually exclusive or when capital rationing is necessary. When projects are mutually exclusive, ranking enables the firm to determine which project is best from a financial standpoint. When capital rationing is necessary, ranking projects will provide a logical starting point for determining what group of projects to accept. As we’ll see, conflicting rankings using NPV and IRR result from differences in the magnitude and timing of cash flows. The underlying cause of conflicting rankings is different implicit assumptions about the reinvestment of intermediate cash inflows—cash inflows received prior to the termination of a project. NPV assumes that intermediate cash inflows are reinvested at the cost of capital, whereas IRR assumes that intermediate cash inflows are invested at a rate equal to the project’s IRR.5 These differing assumptions can be demonstrated with an example. 5. To eliminate the reinvestment rate assumption of the IRR, some practitioners calculate the modified internal rate of return (MIRR). The MIRR is found by converting each operating cash inflow to its future value measured at the end of the project’s life and then summing the future values of all inflows to get the project’s terminal value. Each future value is found by using the cost of capital, thereby eliminating the reinvestment rate criticism of the traditional IRR. The MIRR represents the discount rate that causes the terminal value just to equal the initial investment. Because it uses the cost of capital as the reinvestment rate, the MIRR is generally viewed as a better measure of a project’s true profitability than the IRR. Although this technique is frequently used in commercial real estate valuation and is a preprogrammed function on some sophisticated financial calculators, its failure to resolve the issue of conflicting rankings and its theoretical inferiority to NPV have resulted in the MIRR receiving only limited attention and acceptance in the financial literature. For a thorough analysis of the arguments surrounding IRR and MIRR, see D. Anthony Plath and William F. Kennedy, “Teaching Return-Based Measures of Project Evaluation,” Financial Practice and Education (Spring/Summer 1994), pp. 77–86. CHAPTER 9 Capital Budgeting Techniques 409 Reinvestment Rate Comparisons for a Projecta TABLE 9.5 Reinvestment rate Year (1) Cash inflows (2) Number of years earning interest (t) [3 (1)] (3) FVIF10%,t (4) 10% 15% Future value [(2) (4)] (5) FVIF15%,t (6) Future value [(2) (6)] (7) $ 68,796 1 $ 52,000 2 1.210 $ 62,920 1.323 2 78,000 1 1.100 85,800 1.150 89,700 3 100,000 0 1.000 100,000 1.000 100,000 Future value end of year 3 NPV @ 10% $258,496 $16,867 IRR 15% aInitial EXAMPLE $248,720 investment in this project is $170,000. A project requiring a $170,000 initial investment is expected to provide operating cash inflows of $52,000, $78,000, and $100,000 at the end of each of the next 3 years. T...
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This document was uploaded on 01/19/2014.

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