Your boss, the chief financial officer (CFO) for Southern Textiles, has just handed you the estimated cash flows for two proposed projects. Project L involves adding a new item to the firms fabric line. It would take some time to build up the market for this product, so the cash inflows would increase over time. Project S involves an add-on to an existing line, and its cash flows would decrease over time. Both projects have 3-year lives because Southern is planning to introduce an entirely new fabric at that time.

Here are the net cash flow estimates (in thousands of dollars):

Expected Net Cash Flows

Year Project L Project S

0 $(100) $(100)

1 10 70

2 60 50

3 80 20

The CFO also made subjective risk assessments of each project, and he concluded that the projects both have risk characteristics that are similar to the firms average project. Southerns required rate of return is 10%. You must now determine whether one or both of the projects should be accepted. Start by answering the following questions:

A) What are the main disadvantages of the traditional payback? Is the payback method of any real usefulness in capital budgeting decisions?

B) What is each projects NPV?

(1) What is the rationale behind the NPV method? According to NPV, which project or projects should be accepted if they are independent? Mutually exclusive?

(2) Would the NPVs change if the required rate of return changed?

C) What is each projects IRR?

(1) What is the logic behind the IRR method? According to IRR, which projects should be accepted if they are independent? Mutually exclusive?

(2) Would the projects IRRs change if the required rate of return changed? Explain.

(3) Under what circumstances will we get 2 IRRs for the same project?

(D) Define the term modified internal rate of return (MIRR).

(1) How does the MIRR differ from the IRR?

(2) What is the advantage of each capital budgeting technique as explained in lecture recording 12, and which one is most accurate?