Question

Based upon the learning activities in Topic 2, calculate the Internal Rate of Return (IRR), Net Present Value (NPV) and Profitability Index (PI) of earning an MBA at UMass Global assuming the initial cost of one-year MBA program is $20,000 (upfront) that earns you a promotion that increases your annual salary (take-home pay) by $10,000 annually for 5 years. Your cost of capital is 15%. What are the pros and cons of the following capital budgeting techniques: Net Present Value (NPV), Modified Internal Rate of Return (MIRR) and Profitability Index (PI)? Describe capital budgeting risk and two of the methods used in capital budgeting to identify the uncertainties associated with any given capital project.

Answer 1

1. IRR = 15%.

2. NPV = 13,521.55

3. PI = 1.6761

How did we get these values?

Let's start by calculating the Internal Rate of Return (IRR), Net Present Value (NPV), and Profitability Index (PI) for earning an MBA at UMass Global.

Assumptions:

- Initial Cost (Outflow): $20,000

- Annual Salary Increase (Inflow): $10,000 for 5 years

- Cost of Capital (Discount Rate): 15%

Cash Flows:

| Year | Cash Flow |

|---------|----------------|

| 0 | -$20,000 |

| 1 | $10,000 |

| 2 | $10,000 |

| 3 | $10,000 |

| 4 | $10,000 |

| 5 | $10,000 |

Let's calculate IRR, NPV, and PI.

1. Internal Rate of Return (IRR):

The IRR is the discount rate that makes the NPV of cash inflows equal to the initial investment.

`\[ \text{IRR} = \text{Discount Rate} \]`

In this case, IRR = 15%.

2. Net Present Value (NPV):

`\[ \text{NPV} = \sum_(t=0)^(5) \frac{\text{Cash Flow}_t}{(1 + \text{Discount Rate})^t} - \text{Initial Cost} \]`

`\[ \text{NPV} = (10,000)/((1 + 0.15)^1) + (10,000)/((1 + 0.15)^2) + (10,000)/((1 + 0.15)^3) + (10,000)/((1 + 0.15)^4) + (10,000)/((1 + 0.15)^5) - 20,000 \]`

NPV = 33,521.55 - 20,000

NPV = 13,521.55

3. Profitability Index (PI):

`\[ \text{PI} = \frac{\text{PV of Cash Inflows}}{\text{Initial Cost}} \]`

`\[ \text{PI} = ((10,000)/((1 + 0.15)^1) + (10,000)/((1 + 0.15)^2) + (10,000)/((1 + 0.15)^3) + (10,000)/((1 + 0.15)^4) + (10,000)/((1 + 0.15)^5))/(20,000) \]`

PI =
`(8695.65 + 7561.44 + 6575.16 + 5717.53 + 4971.77)/(20,000)`

PI = 1.6761

Let's discuss the pros and cons of the capital budgeting techniques: NPV, MIRR, and PI.

Net Present Value (NPV): Pros: Considers the time value of money, provides a clear indicator of profitability, and aligns with the goal of maximizing shareholder wealth. Cons: May not reflect the project's scale, and it assumes reinvestment of cash inflows at the discount rate.

Modified Internal Rate of Return (MIRR): Pros: Overcomes some of the issues associated with IRR, provides a more realistic reinvestment rate assumption, and considers both inflows and outflows. Cons: Subject to the choice of the financing rate, and interpretation may still vary.

Profitability Index (PI): Pros: Provides a ratio that can be easily understood, considers the time value of money, and aligns with the goal of maximizing shareholder wealth. Cons: Similar to NPV, it assumes reinvestment of cash inflows at the discount rate.

Capital Budgeting Risk: Capital budgeting involves uncertainties, and two methods to identify these uncertainties are:

1. Sensitivity Analysis: Examines how the NPV or other criteria change with variations in key input parameters such as cash flows, discount rates, or project duration.

2. Scenario Analysis: Evaluates the impact of different scenarios on the project's performance by considering various combinations of factors like economic conditions, market trends, or regulatory changes.