Prairie Winds Pasta – Capital Budgeting Methods & Cash Flow Estimation
Summary of Case
Prairie Winds Pasta is experiencing a high demand for pasta from its customers. The customers demand delivery with in one week with a maximum allowance of 10 days. The facility is running at full capacity - 24 hours a day.
Define the term “incremental cash flow.” Since the project will be financed in part by debt, should the cash flow statement include interest expense? Explain.
Incremental cash flows is the difference between the cash flows a company will have if it implements the new project versus the cash flows the company will have if they choose not to embark …show more content…
The discount rate of 11.2% should be used as the company’s cost of capital.
Compute the project’s NPV, IRR, modified IRR (MIRR), payback and PI, and explain the rationale behind each of these capital budgeting models.
NPV – this model estimates cash flows (inflows and outflows); assesses the riskiness of cash flows; determines the appropriate cost of capital; nets out the initial outflow value. If projects are independent, we would accept projects who’s NPV > 0. If projects are mutually exclusive, we would accept projects with the highest NPV.
IRR – is the discount rate that forces PV of inflows equal to cost, and NPV = 0. A project’s IRR is similar to a bond’s YTM. If IRR > WACC, the project’s rate of return is greater than its cost. So, there is some return left over to boost stockholder’s returns. When choosing a project we would choose the one with a higher IRR as long as IRR > WACC.
Modified IRR – this model correctly assumes reinvestment at opportunity cost = WACC. It also avoids the problem of multiple IRR’s. MIRR is a better rate of return comparison than IRR. MIRR is to be used when there are non normal cash flows and more than one IRR.
Payback – this model is easy to compute