Ronald Inc. is considering a project that has the following cash flow data. What is the project’s payback? Which of the following statements is CORRECT?
A. The IRR method appeals to some managers because it gives an estimate of the rate of return on projects rather than a dollar amount, which the NPV method provides.
B. The discounted payback method eliminates all of the problems associated with the payback method.
C. When evaluating independent projects, the NPV and IRR methods often yield conflicting results regarding a project’s acceptability.
D. To find the MIRR, we discount the TV at the IRR.
The correct answer and explanation is:
To answer the question regarding Ronald Inc.’s project and the correct statement, let’s break down the key concepts.
Payback Period Calculation:
The payback period measures how long it takes for an investment to recoup its initial outlay. To calculate the payback period, you simply sum the cash flows until they equal the initial investment. However, since no specific cash flow data is provided here, I can’t calculate the exact payback. But in general:
- Sum the cash flows for each period.
- Identify when the cumulative cash flow equals the initial investment.
Evaluating the Statements:
Let’s analyze each statement:
A. The IRR method appeals to some managers because it gives an estimate of the rate of return on projects rather than a dollar amount, which the NPV method provides.
- Correct. The Internal Rate of Return (IRR) method calculates the percentage rate at which the project breaks even in terms of net present value. It’s often preferred by managers who want to understand the project’s potential return as a percentage, rather than the absolute dollar value provided by NPV.
B. The discounted payback method eliminates all of the problems associated with the payback method.
- Incorrect. While the discounted payback method addresses the problem of not accounting for the time value of money (by discounting future cash flows), it doesn’t solve all issues. It still ignores cash flows beyond the payback period and doesn’t consider the full profitability of the project.
C. When evaluating independent projects, the NPV and IRR methods often yield conflicting results regarding a project’s acceptability.
- Incorrect. For independent projects (projects that are not mutually exclusive), the NPV and IRR methods generally do not conflict. Both methods should agree on whether a project is acceptable as long as the IRR is above the required rate of return and NPV is positive.
D. To find the MIRR, we discount the TV at the IRR.
- Incorrect. The Modified Internal Rate of Return (MIRR) is found by discounting the terminal value (TV) at the firm’s cost of capital (WACC), not at the IRR.
Conclusion:
The correct statement is A. The IRR method is preferred by some managers because it provides a percentage rate of return, whereas NPV provides a dollar amount.