The use of NPV , IRR and MIRR in valuation
The use of the three methods assumes prepared cash flows for at least five years. Before cash flows could be prepared, projected income statement and projected balance sheet for the at least five years should be made. Since there are no estimated revenues from cases facts what could be assumed is that the additional financing that would be needed by either debt financing or equity whatever the company would choose should pass first and foremost the net present value (NPV) test before the others.
The NPV method assumes cost of capital as discount rate in discounting the projected cash flows as stated earlier. If the net present value the project is positive, then it is acceptable, otherwise the proposal to make expansion should be rejected for the meantime and wait for better time. The IRR stands for internal rate of rate which can be used also to evaluate the acceptability of project proposal. A proposal is acceptable if its IRR is greater than the company’s cost of capital.
In case of mutually exclusive projects the use of NPV is better than IRR because the latter assumes the IRR to be the reinvestment rate while NPV assumes the cost of capital. Modified IRR (MIRR) is an improved version of IRR which is computed by getting the present of the terminal value where the terminal is equal to the sum of future values of cash inflows (Brigham and Houston, 2002). 2. 3. 2. How to apply the valuation method in relation to cash flows?
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To apply the valuation methods there is a need to know the company’s cost of capital to be used as discount rate. However, case facts do not provide complete information to compute the said discount rate. 2. 3. 3 How to relate outline of the financial plans as required by CFO for the next 12 months to the cash flow? The three financial statements for the end of the fiscal year will just confirm the viability of the capital investments required and the planned IPO or the debt financing whichever is chosen.
The financial plans will include the projected income statement, balance sheet and cash flow for the next 12 months. 3. Conclusion The company has positive net working capital of not less than $40 on the average for the years 2001 through 2003, high liquidity of more than 2. 0 and good solvency (Meigs and Meigs, 1995) of less than 0. 50 which may justify financing via debt instead of IPO. To determine the choice of IPO or debt financing, there is a need to know the level of capital investments required so that new capital structure may be evaluated properly.
But the capacity to borrow of at $80 million as Table I has indicated without affecting company solvency may be hard to avoid. To finally say whether expansion should be pursued there is a need to have cost of capital first by having additional accounting information.
Meigs and Meigs, 1995, Financial Accounting, McGraw-Hill, Inc. , New York USA Brigham and Houston (2002) Fundamentals of Financial Management, Thomson South-Western, US Case Study- Superior Living with Balance Sheet for the years 2001 through 2003.