# Case Study

Case #82

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.

Question 1

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.

Response:

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

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Response:

The discount rate of 11.2% should be used as the company’s cost of capital.

Question 8

Compute the project’s NPV, IRR, modified IRR (MIRR), payback and PI, and explain the rationale behind each of these capital budgeting models.

Response:

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