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- 86971984 FI515 Homework3 Answers
- Untitled
- FI504 Case Study 3 Cash Budget
- Financial Management_ Eugene F. Brigham and Michael C. Ehrhardt_ 20086
- Test Bank Chapter12
- Course Project - Part A - Math 533
- Project Case 9-30 Master Budget
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- Case Study 1 Week 3
- Acct 2251 Enlarged Review Qs Final ExamW07
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ANSWERS TO END-OF-CHAPTER QUESTIONS

analysis is required to evaluate a given project, the level of the

executive who must approve the project, and the cost of capital that

should be used to calculate the project’s NPV. Thus, classification

schemes can increase the efficiency of the capital budgeting process.

10-2 The NPV is obtained by discounting future cash flows, and the

discounting process actually compounds the interest rate over time.

Thus, an increase in the discount rate has a much greater impact on a

cash flow in Year 5 than on a cash flow in Year 1.

10-3 This question is related to Question 10-2 and the same rationale

applies. With regard to the second part of the question, the answer is

no; the IRR rankings are constant and independent of the firm’s cost of

capital.

10-4 The NPV and IRR methods both involve compound interest, and the

mathematics of discounting requires an assumption about reinvestment

rates. The NPV method assumes reinvestment at the cost of capital,

while the IRR method assumes reinvestment at the IRR. MIRR is a

modified version of IRR that assumes reinvestment at the cost of

capital.

10-5 The statement is true. The NPV and IRR methods result in conflicts

only if mutually exclusive projects are being considered since the NPV

is positive if and only if the IRR is greater than the cost of capital.

If the assumptions were changed so that the firm had mutually exclusive

projects, then the IRR and NPV methods could lead to different

conclusions. A change in the cost of capital or in the cash flow

streams would not lead to conflicts if the projects were independent.

Therefore, the IRR method can be used in lieu of the NPV if the

projects being considered are independent.

10-6 Yes, if the cash position of the firm is poor and if it has limited

access to additional outside financing it might be better off to choose

a machine with a rapid payback. But even here, the relationship

between present value and cost would be a better decision tool.

to maximize value, and as we point out in subsequent chapters, stock

values are determined by both earnings and growth. The NPV

calculation automatically takes this into account, and if the NPV of

a long-term project exceeds that of a short-term project, the higher

future growth from the long-term project must be more than enough to

compensate for the lower earnings in early years.

with a faster payback--reported profits would have been higher for a

period of years. This is, of course, another reason why firms

sometimes use the payback method.

10-8 Mutually exclusive projects are a set of projects in which only one of

the projects can be accepted. For example, the installation of a

conveyor-belt system in a warehouse and the purchase of a fleet of

forklifts for the same warehouse would be mutually exclusive projects--

accepting one implies rejection of the other. When choosing between

mutually exclusive projects, managers should rank the projects based on

the NPV decision rule. The mutually exclusive project with the highest

positive NPV should be chosen. The NPV decision rule properly ranks

the projects because it assumes the appropriate reinvestment rate is

the cost of capital.

10-9 Project X should be chosen over Project Y. Since the two projects are

mutually exclusive, only one project can be accepted. The decision

rule that should be used is NPV. Since Project X has the higher NPV,

it should be chosen. The cost of capital used in the NPV analysis

appropriately includes risk.

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

12, and then solve for NPV = $7,486.68.

10-3 Financial Calculator Solution: Input CF0 = -52125, CF1-8 = 12000, and

then solve for IRR = 16%.

Period Cash Flows Cash Flows Cumulative

0 ($52,125) ($52,125.00) ($52,125.00)

1 12,000 10,714.29 (41,410.71)

2 12,000 9,566.33 (31,844.38)

3 12,000 8,541.36 (23,303.02)

4 12,000 7,626.22 (15,676.80)

5 12,000 6,809.12 (8,867.68)

6 12,000 6,079.57 (2,788.11)

7 12,000 5,428.19 2,640.08

8 12,000 4,846.60 7,486.68

$2,788. 11

The discounted payback period is 6 + years, or 6.51 years.

$5,42 8.19

Alternatively, since the annual cash flows are the same, one can divide

$12,000 by 1.12 (the discount rate = 12%) to arrive at CF1 and then

continue to divide by 1.12 seven more times to obtain the discounted

cash flows (Column 3 values). The remainder of the analysis would be

the same.

FV Inflows:

PV FV

0 1 2 3 4 5 6 7 8

12%

| | | | | | | | |

12,000 12,000 12,000 12,000 12,000 12,000 12,000

× 1.12 12,000

× (1.12)2 13,440

× (1.12)

3 15,053

× (1.12)4

16,859

× (1.12)5 18,882

× (1.12)6 21,148

× (1.12)7 23,686

Integrated Case: 10 - 3

26,528

52,125 MIRR =

13.89% 147,596

Financial Calculator Solution: Obtain the FVA by inputting N = 8, I =

12, PV = 0, PMT = 12000, and then solve for FV = $147,596. The MIRR

can be obtained by inputting N = 8, PV = -52125, PMT = 0, FV = 147596,

and then solving for I = 13.89%.

10-6 Project A:

CF0 = -15000000

CF1 = 5000000

CF2 = 10000000

CF3 = 20000000

Change I = 5 to I = 15; NPV = $10,059,587.

Project B:

CF0 = -15000000

CF1 = 20000000

CF2 = 10000000

CF3 = 6000000

Change I = 5 to I = 15; NPV = $13,897,838.

10-7 Truck:

and then solve for NPV = $408.71 ≈ $409 and IRR = 1499% ≈ 15%.

FV Inflows:

PV FV

0 14% 1 2 3 4 5

| | | | | |

5,100 5,100 5,100 5,100

× 1.14 5,100

× (1.14)2 5,814

× (1.14)3 6,628

Integrated Case: 10 - 4

7,556

× (1.14)4

8,614

17,100 MIRR = 14.54% (Accept) 33,712

Financial Calculator Solution: Obtain the FVA by inputting N = 5, I =

14, PV = 0, PMT = 5100, and then solve for FV = $33,712. The MIRR can

be obtained by inputting N = 5, PV = -17100, PMT = 0, FV = 33712, and

then solving for I = MIRR = 14.54%.

Pulley:

and then solve for NPV = $3,318.11 ≈ $3,318 and IRR = 20%.

FV Inflows:

PV FV

0 1 2 3 4 5

14%

| | | | | |

7,500 7,500 7,500 7,500

× 1.14 7,500

× (1.14)2 8,550

× (1.14)

3 9,747

× (1.14)4 11,112

12,667

22,430 MIRR = 17.19% (Accept) 49,576

14, PV = 0, PMT = 7500, and then solve for FV = $49,576. The MIRR can

be obtained by inputting N = 5, PV = -22430, PMT = 0, FV = 49576, and

then solving for I = 17.19%.

IRRS = 15.24%; IRRL = 14.67%.

MIRR:

PV costsS = $15,000.

FV inflowsS = $29,745.47.

MIRRS = 14.67%.

PV costsL = $37,500.

FV inflowsL = $73,372.16.

MIRRL = 14.37%.

Thus, NPVL > NPVS, IRRS > IRRL, and MIRRS > MIRRL. The scale difference

between Projects S and L results in IRR and MIRR selecting S over L.

However, NPV favors Project L, and hence Project L should be chosen.

Integrated Case: 10 - 5

10-9 a. The IRRs of the two alternatives are undefined. To calculate an

IRR, the cash flow stream must include both cash inflows and

outflows.

of costs for the forklift system is -$493,407. Thus, the forklift

system is expected to be -$493,407 - (-$556,717) = $63,310 less

costly than the conveyor system, and hence the forklifts should be

used.

| | | | |

-1,000 100 300 400

× 1.12 700.00

× (1.12)2 448.00

× (1.12)3 376.32

140.49

1,000 13.59% = MIRRX 1,664.81

Project Y: 0 12% 1 2 3 4

| | | | |

-1,000 1,000 100 50

× 1.12

50.00

× (1.12)2

56.00

× (1.12)3

125.44

1,404.93

1,000 13.10% = MIRRY 1,636.37

Alternate step: You could calculate NPVs, see that Project X has the

higher NPV, and just calculate MIRRX.

10-11 Input the appropriate cash flows into the cash flow register, and then

calculate NPV at 10 percent and the IRR of each of the projects:

IRRL = 11.74%.

Integrated Case: 10 - 6

0 12% 1 10

| | • • • |

-1,000 PMT PMT

and FV = 0 to obtain PMT = $176.98.

0 10% 1 2 9 10

| | | • • • | |

-1,000 176.98 176.98 176.98

× 1.10 176.98

194.68

.

.

× (1.10)8 .

× (1.10)9 379.37

417.31

1,000 10.93% = MIRR TV = 2,820.61

10, PV = 0, and PMT = -176.98 to obtain FV = $2,820.61. Then

input

N = 10, PV = -1000, PMT = 0, and FV = 2820.61 to obtain

I = MIRR = 10.93%.

Installation 165,000

Initial outlay $1,065,000

NPV = $136,578; IRR = 19.22%.

because its NPV is positive and its IRR is greater than the firm’s

cost of capital.

other cash outflows that might be imposed on the firm to help return

the land to its previous state (if possible). These outflows could

be so large as to cause the project to have a negative NPV, in which

case the project should not be undertaken.

0 ($20,000) ($20,000)

1 75,000 ($5,000) ($10,000) 60,000

2 52,500 (3,500) (10,000) 39,000

3 22,500 (1,500) 21,000

Integrated Case: 10 - 7

NPV = $60,000/(1.11)1 + $39,000/(1.11)2 + $21,000/(1.11)3 - $20,000

= $81,062.35.

39000, CF3 = 21000, and then solve for IRR = 261.90%.

However, ask your students “Does this service encourage cheating?”

If yes, does a businessperson have a social responsibility not to

make this service available?

left, payment at end of month.

New lease terms: $0/month for 9 months; $2,600/month for 51 months.

a. 0 1% 1 2 59 60

| | | • • • | |

-2,000 -2,000 -2,000 -2,000

PV = -$89,910.08.

0 1% 1 9 10 59 60

| | • • • | | • • • | |

0 0 -2,600 -2,600 -2,600

= -$94,611.45.

Sharon should not accept the new lease because the present value of

its cost is $94,611.45 - $89,910.08 = $4,701.37 greater than the old

lease.

b. 0 1% 1 2 9 10 59 60

| | | • • • | | • • • | |

-2,000 -2,000 -2,000 PMT PMT PMT

FV of first 9 months’ rent under old lease:

N = 9; I = 1; PV = 0; PMT = -2000; FV = ? FV = $18,737.05.

51-period annuity whose payments represent the incremental rent

during months 10-60. To find this value:

N = 51; I = 1; PV = -18737.05; FV = 0; PMT = ? PMT = $470.80.

Thus, the new lease payment that will make her indifferent is $2,000

+ $470.80 = $2,470.80.

Check:

Integrated Case: 10 - 8

0 1% 1 9 10 59 60

| | • • • | | • • • | |

0 0 -2,470.80 -2,470.80 -2,470.80

PV cost of new lease: CF0 = 0; CF1 - 9 = 0; CF10 - 60 = -2470.80; I = 1.

NPV = -$89,909.99.

Except for rounding; the PV cost of this lease equals the PV cost of

the old lease.

c. Period Old Lease New Lease ∆Lease

0 0 0 0

1-9 -2,000 0 -2,000

10-60 -2,000 -2,600 600

the periodic rate. To obtain the nominal cost of capital, multiply

by 12: 12(0.019113) = 22.94%.

$71,038.98.

10-16 a. The payback periods for Projects A and B are calculated as follows:

Project A Project B

Period Cash flows Cumulative (A) Cash flows Cumulative

(B)

0 ($400) ($400) ($600) ($600)

1 55 (345) 300 (300)

2 55 (290) 300 0

3 55 (235) 50 50

4 225 (10) 50 100

5 225 215 50 150

payback is 2 years. According to the payback rule, Project B would

be preferred to Project A.

as follows:

Disc. @ 10% Disc. @ 10%

Project A Project B

Period Cash flows Cumulative (A) Cash flows Cumulative

Integrated Case: 10 - 9

(B)

0 ($400.00) ($400.00) ($600.00) ($600.00)

1 50.00 (350.00) 272.73 (327.27)

2 45.45 (304.55) 247.93 (79.34)

3 41.32 (263.22) 37.57 (41.77)

4 153.68 (109.55) 34.15 (7.62)

5 139.71 30.16 31.05 23.42

Project B's payback is 4 + $7.62/$31.05 = 4.245 years. According to

the discounted payback rule, Project B would be preferred to Project

A.

Integrated Case: 10 - 10

c. Finding net present values, use a financial calculator and enter the

following data:

Project A Project B

CF0 = -400 CF0 = -600

CF1 = 55 CF1 = 300

CF2 = 55 CF2 = 300

CF3 = 55 CF3 = 50

CF4 = 225 CF4 = 50

CF5 = 225 CF5 = 50

I = 10 I = 10

NPV = $30.16 NPV = $23.42

d. Finding the IRR, use a financial calculator and enter the following:

Project A Project B

CF0 = -400 CF0 = -600

CF1 = 55 CF1 = 300

CF2 = 55 CF2 = 300

CF3 = 55 CF3 = 50

CF4 = 225 CF4 = 50

CF5 = 225 CF5 = 50

IRR = 12.21% IRR = 12.28%

According to the IRR criterion, Project B is preferred to Project A.

e. Project A:

0 10% 1 2 3 4 5

| | | | | |

-400 55 55 55 225

× 1.10 225

× (1.10)2 247.50

× (1.10)

3 66.55

× (1.10)4 73.21

80.53

692.78

$400 = $692.78/(1 + MIRRA )5

MIRRA = 11.61%.

Project B:

0 10% 1 2 3 4 5

| | | | | |

-600 300 300 50 50

× 1.10

50

× (1.10)2

55.00

× (1.10)3

60.50

× (1.10)4

399.30

439.23

1,004.03

MIRRA = 10.85%.

Integrated Case: 10 - 11

According to the MIRR criterion, Project A is the superior project.

10-17 Since the IRR is the cost of capital at which the NPV of a project

equals zero, the projects inflows can be evaluated at the IRR and the

present value of these inflows must equal the initial investment.

Using a financial calculator enter the following:

CF0 = 0

CF1 = 7500

Nj = 10

CF1 = 10000

Nj = 10

I = 10.98; NPV = $65,002.11.

Using a calculator, the project's NPV can now be solved.

CF0 = -65002.11

CF1 = 7500

Nj = 10

CF1 = 10000

Nj = 10

I = 9; NPV = $10,239.20.

10-18 The MIRR can be solved with a financial calculator by finding the

terminal future value of the cash inflows and the initial present value

of cash outflows, and solving for the discount rate that equates these

two values. In this instance, the MIRR is given, but a cash outflow is

missing and must be solved for. Therefore, if the terminal future

value of the cash inflows is found, it can be entered into a financial

calculator, along with the number of years the project lasts and the

MIRR, to solve for the initial present value of the cash outflows. One

of these cash outflows occurs in Year 0 and the remaining value must be

the present value of the missing cash outflow in Year 2.

Cash inflows Compounding Rate FV in Year 5 @ 10%

CF1 = 202 × (1.10)4 295.75

CF3 = 196 × (1.10)2 237.16

CF4 = 350 × 1.10 385.00

CF5 = 451 × 1.00 451.00

1368.91

Using the financial calculator to solve for the present value of cash

outflows:

N = 5

I = 14.14

PV = ?

PMT = 0

FV = 1368.91

The total present value of cash outflows is $706.62, and since the outflow

Integrated Case: 10 - 12

for Year 0 is $500, the present value of the Year 2 cash outflow is

$206.62. Therefore, the missing cash outflow for Year 2 is $206.62 ×(1.1)2

= $250.01.

10-19 a. At k = 12%, Project A has the greater NPV, specifically $200.41 as

compared to Project B’s NPV of $145.93. Thus, Project A would be

selected. At k = 18%, Project B has an NPV of $63.68 which is

higher than Project A’s NPV of $2.66. Thus, choose Project B if k =

18%.

b.

N

PV

($

)

1

,000

9

0 0

8

0 0

7

0 0

6

0 0

5

0 0

P

roje

ctA

4

0 0

3

0 0

2

0 0

P

roje

ctB

1

0 0 C

ostof

C

apita

l (%

)

5 1

0 1

5 2

0 2

5 3

0

-100

-200

-300

k NPVA NPVB

0.0% $890 $399

10.0 283 179

12.0 200 146

18.1 0 62

20.0 (49) 41

24.0 (138) 0

30.0 (238) (51)

c. IRRA = 18.1%; IRRB = 24.0%.

difference in the two projects’ cash flows:

Project ∆ =

Year CFA - CFB

0 $ 105

1 (521)

2 (327)

3 (234)

4 466

5 466

6 716

7 (180)

IRR∆ = Crossover rate = 14.53%.

Integrated Case: 10 - 13

Projects A and B are mutually exclusive, thus, only one of the

projects can be chosen. As long as the cost of capital is greater

than the crossover rate, both the NPV and IRR methods will lead to

the same project selection. However, if the cost of capital is less

than the crossover rate the two methods lead to different project

selections--a conflict exists. When a conflict exists the NPV

method must be used.

Because of the sign changes and the size of the cash flows, Project

∆ has multiple IRRs. Thus, a calculator’s IRR function will not work.

One could use the trial and error method of entering different discount

rates until NPV = $0. However, an HP can be “tricked” into giving the

roots. After you have keyed Project Delta’s cash flows into the cash

flow registers of an HP-10B, you will see an “Error-Soln” message. Now

enter 10 STO IRR/YR and the 14.53 percent IRR is found. Then

enter 100 STO IRR/YR to obtain IRR = 456.22%. Similarly, Excel

can also be used.

+ $100/(1.12)3 + $180/(1.12)7 = $952.00.

TV inflows = $600(1.12)3 + $600(1.12)2 + $850(1.12)1 = $2,547.60.

7 years to equal $952.00.

=

-952, PMT = 0, and FV = 2547.60. Then solve for I = MIRRA = 15.10%.

Similarly, MIRRB = 17.03%.

At k = 18%,

MIRRA = 18.05%.

MIRRB = 20.49%.

10-20 a.

NPV

(Millio

nso

fDolla

rs)

30

PlanB

2

4

18

1

2

C

rossoverR

ate=16.07%

6 Plan A

IRR A =20%

2

. 4

k(%)

0 5 1

0 1

5 20 2

5

IRR B =16.7%

Integrated Case: 10 - 14

The crossover rate is approximately 16 percent. If the cost of

capital is less than the crossover rate, then Plan B should be

accepted; if the cost of capital is greater than the crossover rate,

then Plan A is preferred. At the crossover rate, the two projects’

NPVs are equal. Thus, other criteria such as the IRR must be used to

evaluate the projects. The exact crossover rate is calculated as

16.07 percent, the IRR of Project ∆, the difference between the cash

flow streams of the two projects.

b. Yes. Assuming (1) equal risk among projects, and (2) that the cost

of capital is a constant and does not vary with the amount of

capital raised, the firm would take on all available projects with

returns greater than its 12 percent cost of capital. If the firm

had invested in all available projects with returns greater than 12

percent, then its best alternative would be to repay capital. Thus,

the cost of capital is the correct reinvestment rate for evaluating

a project’s cash flows.

IRRA = 15.03%. IRRB = 22.26%.

b.

NPV

(Millions of Dollars)

80

60

40

20

IRR S = 22.26%

0

5 10 1 5 20 25 k (%)

-10 IRR A = 15.03%

The exact crossover rate is calculated as 11.7 percent, the IRR of

Project ∆, which represents the differences between the cash flow

streams of the two projects.

reinvest the cash flows generated by a project at the cost of

capital, while use of the IRR method implies the opportunity to

reinvest at the IRR. The firm will invest in all independent

projects with an NPV > $0. As cash flows come in from these

Integrated Case: 10 - 15

projects, the firm will either pay them out to investors, or use

them as a substitute for outside capital which, in this case, costs

10 percent. Thus, since these cash flows are expected to save the

firm 10 percent, this is their opportunity cost reinvestment rate.

The IRR method assumes reinvestment at the internal rate of

return itself, which is an incorrect assumption, given a constant

expected future cost of capital, and ready access to capital markets.

10-22 a. The project’s expected cash flows are as follows (in millions of

dollars):

0 ($ 2.0)

1 13.0

2 (12.0)

We can construct the following NPV profile:

NPV

(MillionsofD

ollars)

1.5

1.0

0.5

-0.5

-1.0 k(%)

0 100 200 300 400 500

k NPV

0% ($1,000,000)

10 (99,174)

50 1,333,333

80 1,518,519

100 1,500,000

200 1,000,000

300 500,000

400 120,000

410 87,659

420 56,213

430 25,632

450 (33,058)

b. If k = 10%, reject the project since NPV < $0. Its NPV at k = 10%

is equal to -$99,174. But if k = 20%, accept the project because NPV

> $0. Its NPV at k = 20% is $500,000.

Integrated Case: 10 - 16

c. Other possible projects with multiple rates of return could be

nuclear power plants where disposal of radioactive wastes is

required at the end of the project’s life.

d. MIRR @ k = 10%:

FV inflows = $13,000,000 × 1.10 = $14,300,000.

MIRR = 9.54%. (Reject the project since MIRR < k.)

Integrated Case: 10 - 17

MIRR @ k = 20%:

FV inflows = $13,000,000 × 1.20 = $15,600,000.

MIRR = 22.87%. (Accept the project since MIRR > k.)

Looking at the results, this project’s MIRR calculations lead to the

same decisions as the NPV calculations. However, the MIRR method

will not always lead to the same accept/reject decision as the NPV

method. Decisions in which two mutually exclusive projects are

involved and differ in scale (size), MIRR can conflict with NPV. In

those situations, the NPV method should be used.

Annual

Period Cash Flows Cumulative

0 ($25,000) ($25,000)

1 5,000 (20,000)

2 10,000 (10,000)

3 15,000 5,000

4 20,000 25,000

PaybackA = 2 + $10,000/$15,000 = 2.67 years.

Payback B (cash flows in thousands):

Annual

Period Cash Flows Cumulative

0 ($25,000) ($25,000)

1 20,000 (5,000)

2 10,000 5,000

3 8,000 13,000

4 6,000 19,000

PaybackB = 1 + $5,000/$10,000 = 1.50 years.

b. Discounted payback A (cash flows in thousands):

Annual Discounted @10%

Period Cash Flows Cash Flows Cumulative

0 ($25,000) ($25,000.00) ($25,000.00)

1 5,000 4,545.45 (20,454.55)

2 10,000 8,264.46 (12,190.09)

3 15,000 11,269.72 (920.37)

4 20,000 13,660.27 12,739.90

Discounted PaybackA = 3 + $920.37/$13,660.27 = 3.07 years.

Discounted payback B (cash flows in thousands):

Annual Discounted @10%

Period Cash Flows Cash Flows Cumulative

0 ($25,000) ($25,000.00) ($25,000.00)

1 20,000 18,181.82 (6,818.18)

2 10,000 8,264.46 1,446.28

3 8,000 6,010.52 7,456.80

4 6,000 4,098.08 11,554.88

Integrated Case: 10 - 18

Discounted PaybackB = 1 + $6,818.18/$8,264.46 = 1.825 years.

NPVB = $11,554,880; IRRB = 36.15%.

undertaken.

At a discount rate of 5 percent, NPVB = $14,964,829.

consequently, it should be accepted.

At a discount rate of 15 percent, NPVB = $8,643,390.

consequently, it should be accepted.

f. Project ∆ =

Year CFA - CFB

0 $ 0

1 (15)

2 0

3 7

4 14

Step 1: Calculate the NPV of the uneven cash flow stream, so its FV

can then be calculated. With a financial calculator, enter

the cash flow stream into the cash flow registers, then

enter I = 10, and solve for NPV = $37,739,908.

Enter N = 4, I = 10, PV = -37739908, and PMT = 0 to solve

for FV = $55,255,000.

solve for I = 21.93%.

Step 1: Calculate the NPV of the uneven cash flow stream, so its FV

can then be calculated. With a financial calculator, enter

the cash flow stream into the cash flow registers, then

enter I = 10, and solve for NPV = $36,554,880.

Integrated Case: 10 - 19

Step 2: Calculate the FV of the cash flow stream as follows:

Enter N = 4, I = 10, PV = -36554880, and PMT = 0 to solve

for FV = $53,520,000.

Enter N = 4, PV = -25000000, PMT = 0, and FV = 53520000 to

solve for I = 20.96%.

exclusive, Project A would be chosen because it has the higher MIRR.

This is consistent with the NPV approach. Note: Because these two

projects are equal in size, we don’t need to worry about a conflict

between the MIRR and NPV decisions.

Integrated Case: 10 - 20

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