The IRR evaluation method assumes that cash flows from the p

The IRR evaluation method assumes that cash flows from the project are reinvested at the same rate equal to the IRR. However, in reality the reinvested cash flows may not necessarily generate a return equal to the IRR. Thus, the modified IRR approach makes a more reasonable assumption other than the project\'s IRR. Consider the following situation: Celestial Crane Cosmetics is analyzing a project that requires an initial investment of $400,000. The project\'s expected cash flows are: Year Cash Flo Year 1 $300,000 Year 2 -125,000 Year 3 475,000 Year 4 450,000 Celestial Crane Cosmetics\'s WACC is 8%, and the project has the same risk as the firm\'s average project. Calculate this project\'s modified internal rate of return (MIRR): o 26.14% 31.65% 27.52% 33.02% If Celestial Crane Cosmetics\'s managers select projects based on the MIRR criterion, they should independent project. this 2 3 4 6 W E

Solution

For MIRR calculation following steps has to be followed:

Unconventional cash flow given WACC is 8%=0.08

Year 0 Year 1 Year 2 Year 3 Year 4

-400000 300000 -125000 475000 450000

Step 1 : Calculate PV of outflows

-4000000*1 + (-125000/(1+0.08)²) = 507167.35

Step 2 : Calculate FV of inflows

300000(1+0.08)³+475000(1+1.08)+450000 = 1340913.6

Step 3: equate PV of outflows with PV of FV of inflows and solve for K (here K is MIRR)

No.of time periods is 4.

507167.35 = 1340913.6/(1+k)⁴

from this solve for K we will get K = 0.2751

= 27.51 % (MIRR)

So option C.

As MIRR is greater than WACC we should accept the project

So Celestial Crane Projects should accept this independent project.

Which of the following best describes......

C. The IRR method assumes that cashflows are re invested at the rate equal to IRR. The MIRR method assumes that cashflows are re invested at the rate equal to cost of capital.