Hello!
In order to solve this, we have to calculate the net operating cash
flows in each of the years that the project will last. In this case,
we're told that the plant will be leased for 5 years.
The initial outlay is clearly $4,000,000.
The cash flow in each of the following years is found in this way. We
know that there will be savings of $3,500,000. Furthermore, there will
be a lease cost of $1,500,000 per year and additional expenses for
$150,000. Therefore, the net income before depreciation and taxes
would be:
NI before dep and taxes = 3500000  1500000  150000 = $1,850,000
The depreciation would be $800,000 per year (you have to depreciate a
value of $4,000,000 straightline over 5 years, so the depreciation
per year would be 4000000/5 = 800000). Therefore, the net income
before taxes would be:
NI before taxes = 1850000  800000 = $1,050,000
Finally, taxes are 40% of the value we've just found, which amounts to
$420,000. Therefore, net income in years 1 through 5 would be:
NI = 1050000  420000 = $630,000
Finally, in order to find the operating cash flows we add the
depreciation to the net income, since the depreciation is not paid to
anyone, so it's not actually a cash outflow. We get:
Operating Cash Flow = 630000 + 800000 = $1,430,000
So that's the operating cash flow in years 1 through 5. We now simply
need to calculate the MIRR. This can be done in Excel. I've prepared
an Excel sheet, which you can find at
http://www.filefactory.com/file/dcdfd2/
As you can see, the MIRR of the project is 18%. In order for the
project to be accepted, its MIRR should be higher than the hurdle
rate. Therefore, we conclude that:
Hurdle Rate 10% : ACCEPT
Hurdle Rate 15% : ACCEPT
Hurdle Rate 20% : REJECT
Google search terms
mirr
://www.google.com/search?hl=es&q=mirr&lr=
"hurdle rate"
://www.google.com/search?hl=es&q=%22hurdle+rate%22&lr=
operating cash flow
://www.google.com/search?hl=es&q=operating+cash+flow&lr=
I hope this helps! If you have any doubt regarding my answer, please
don't hesitate to request clarification before rating it. Otherwise, I
await your rating and final comments.
Best wishes!
elmarto 
Clarification of Answer by
elmartoga
on
04 Sep 2006 10:33 PDT
Hello again!
There's not much that can be said about how the project would fair
under different hurdle rates except for the acceptance/rejection of
the project. The hurdle rate is the required rate of return of a
project, based on the cost of capital of the firm and the risk
associated with the specific project. If the return of the project (in
this case, measured through the MIRR) doesn't exceed the hurdle rate,
then it's not worthwhile to undertake the project, either because its
return doesn't compensate for the cost of raising the funds needed to
accept, or it doesn't compensate for the risk associated with the
project, or both.
In your case, the return of the project is 18%. Therefore, when the
hurdle rate is 20%, it's not convenient to accept the project for the
reasons stated above. If the hurdle rate is lower than 18% and there
are no other attractive projects for the firm (as in this case, in
which no other projects are mentioned), then the return does
compensate for the cost of capital plus the risk premium, so the
project should be accepted.
Regarding the balance sheet, you're correct: since we're given all the
necessary information (cost of capital, reinvestment rate, etc.), we
don't need the balance sheet in order to evaluate this leasing
project.
Best regards,
elmarto
