Question #54821

Dunia Construction Co. (DCC) is considering a new inventory system that will cost
RM750,000. The system is expected to generate positive cash flows over the next
four years in the amounts of RM350,000 in year one, RM325,000 in year two,
RM150,000 in year three, and RM180,000 in year four. DCC's required rate of return
is 8%.
i. What is the net present value of this project?
ii. What is the internal rate of return of this project?
iii. What is the modified internal rate of return of this project?

Expert's answer

Dunia Construction Co. (DCC) is considering a new inventory system that will cost RM750,000. The system is expected to generate positive cash flows over the next four years in the amounts of RM350,000 in year one, RM325,000 in year two, RM150,000 in year three, and RM180,000 in year four. DCC's required rate of return is 8%.

i. The net present value of this project is NPV = -750,000 + 350,000/1.08 + 325,000/1.08^2 + 150,000/1.08^3 + 180,000/1.08^4 = 104,089.4

ii. The internal rate of return of this project is 15.13% (NPV = 0).

iii. While the internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR, the modified IRR assumes that positive cash flows are reinvested at the firm's cost of capital, and the initial outlays are financed at the firm's financing cost. Therefore, MIRR more accurately reflects the cost and profitability of a project.

i. The net present value of this project is NPV = -750,000 + 350,000/1.08 + 325,000/1.08^2 + 150,000/1.08^3 + 180,000/1.08^4 = 104,089.4

ii. The internal rate of return of this project is 15.13% (NPV = 0).

iii. While the internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR, the modified IRR assumes that positive cash flows are reinvested at the firm's cost of capital, and the initial outlays are financed at the firm's financing cost. Therefore, MIRR more accurately reflects the cost and profitability of a project.

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