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Project Classification, NPV, IRR, and MIRR

1. How is a project classification scheme (for example, replacement, expansion into new markets, and so forth) used in the capital budgeting process?

2. Explain why the NPV of a relatively long-term project, defined as one for which a high percentage of its cash flows are expected in the distant future, is more sensitive to changes in the cost of capital than is the NPV of a short-term project.

3. Explain why, if tow mutually exclusive projects are being compared, the short-term project might have the higher ranking under the NPV criterion if the cost of capital is high, but the long-term project might be deemed better if the cost of capital is low. Would changes in the cost of capital ever cause a change in the IRR ranking of two such projects?

4. In what sense is a reinvestment rate assumption embodied in the NPV, IRR, and MIRR methods? What is the assumed reinvestment rate of each method?

5. Your company is considering two mutually exclusive projects, X and Y, whose costs and cash flows are shown below:

Year X Y
0 ($1,000) ($1,000)
1 100 1,000
2 300 100
3 400 50
4 700 50

The projects are equally risky, and their cost of capital is 12 percent. You must make a recommendation, and you must base it on the modified IRR (MIRR). What is the MIRR of the better project?

Solution Preview

See the attached file for complete solution. The text here may not be copied exactly as some of the symbols / tables may not print. Thanks

1. How is a project classification scheme (for example, replacement, expansion into new markets, and so forth) used in the capital budgeting process?

The capital budgeting used project classification schemes to formulate policies and help consistency in project evaluation. It is used to:
- How much analysis is required to evaluate a particular project type
- The approving authority for such projects for investment within the firm
- The risk class for such project
- The cost of capital to be used to evaluate such project
Thus, it helps in consistency in project appraisals and approvals.

2. Explain why the NPV of a relatively long-term project, ...

Solution Summary

This post answer five questions from corporate finance on capital investment decisions. It discusses concepts such as IRR, NPV, MIRR, etc. This could be used as a good learning exercise to learn the concepts. This solution is 554 words.

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