Financial Management - Essay Example

With this rule, both projects qualify as good projects, although the pulley project has a higher value. The rule for the internal rate of return states that a given project should only be accepted if the project’s IRR is greater than or equal to the firm’s cost of capital. The firm’s cost of capital is 14%, in which case the truck project yields an IRR of 15%, it is to be accepted; the pulley project’s IRR is also higher than the firm’s cost of capital at 20%. The flaw with using IRR is that the rate of growth of cash flows is assumed to be the IRR’s.

By using the modified IRR or MIRR, the rate of growth of cash flows or the so-called reinvestment rate is the cost of capital, or cost of funding the investment instead of the IRR. The rule for accepting a project based on MIRR is same as the IRR, that is, if MIRR is greater than or equal to the firm’s cost of capital, it should be accepted. Otherwise, it should be rejected as it will not contribute additional value to the firm. By using 14% as the finance rate and reinvestment rate, we get MIRR for the truck project as 14.

5%--higher than the cost of capital, therefore it is to be accepted. With the pulley project, the MIRR is 17%, also higher than the cost of capital so the project should also be accepted. Davis Industries must choose between a gas-powered and an electric-powered forklift truck for moving materials in its factory. Since both forklifts perform the same function, the firm will choose only one. (They are mutually exclusive investments.) The electric-powered truck will cost more, but it will be less expensive to operate; it will cost $22,000, whereas the gas powered truck will cost $17,500.

The cost of capital that applies to both investments is 12%. The life for both types of truck is estimated to be 6 years, during which time the net cash flows for the electric-powered truck will be $6,290 per