Question

Before making capital budgeting decisions, finance professionals often generate, review, analyze, select, and plement long-term investment proposals that meet firm-specific criteria and are consistent with the firms strategic goals. Companies often use several methods to evaluate the projects cash flows and each of them has its benefits and disadvantages.

Based on your understanding of the capital budgeting evaluation methods, which of the following conclusions about capital budgeting are valid? Check all that apply.
a. Because the MIRR and NPV use the same reinvestment rate assumption, they always lead to the same accept/reject decision for mutually exclusive projects.
b. The NPV shows how much value the company is creating for its shareholders.
c. For most firms, the reinvestment rate assumption in the MIRR is more realistic than the assumption in the IRR.
Sophisticated firms use only the NPV method in capital budgeting decisions.
a. true
b. false

Answer 1

The claim that MIRR and NPV always lead to the same decision is false, as they have different reinvestment rate assumptions. NPV is true in showing value creation for shareholders, and MIRR's reinvestment rate assumption is often considered more realistic than that of IRR. Sophisticated firms typically use a combination of methods, not only NPV, for capital budgeting decisions.

Step-by-step explanation:

When considering capital budgeting evaluation methods, it is important to understand the different approaches and the implications they have for making investment decisions. The Modified Internal Rate of Return (MIRR) and the Net Present Value (NPV) are two commonly used methods. Here is a nuanced take on these methods and their application:

• The statement that the MIRR and NPV always lead to the same accept/reject decision for mutually exclusive projects is false. While both consider the time value of money, they use different reinvestment rate assumptions. NPV assumes reinvestment at the project's rate of return, whereas MIRR assumes reinvestment at the firm's cost of capital.
• It is true that the NPV shows how much value is being created for shareholders. A positive NPV indicates a project is expected to generate more cash than the cost of capital, thus adding value to the company.
• It is often argued that the reinvestment rate assumption of MIRR is more realistic than that of the IRR because MIRR uses the firm’s cost of capital, which can be a more conservative and attainable reinvestment rate compared to IRR's potentially optimistic rate.
• While NPV is highly regarded for its direct economic meaning, saying that sophisticated firms use only the NPV method in capital budgeting decisions can be misleading. Many firms use a combination of methods, including NPV, IRR, MIRR, and Payback Period to get a comprehensive view of an investment’s potential.