Question

2. Internal rate of return (IRR)

The internal rate of return (IRR) refers to the compound annual rate of return that a project generates based on its up-front cost and subsequent cash flows. Consider this case of Blue Llama Mining Company:

Blue Llama Mining Company is evaluating a proposed capital budgeting project (project Delta) that will require an initial investment of $1,600,000.

Blue Llama Mining Company has been basing capital budgeting decisions on a project’s NPV; however, its new CFO wants to start using the IRR method for capital budgeting decisions. The CFO says that the IRR is a better method because percentages and returns are easier to understand and to compare to required returns. Blue Llama Mining Company’s WACC is 8%, and project Delta has the same risk as the firm’s average project.

The project is expected to generate the following net cash flows:

Year	Cash Flow
Year 1	$375,000
Year 2	$500,000
Year 3	$450,000
Year 4	$475,000

Which of the following is the correct calculation of project Delta’s IRR?

4.74%

5.69%

4.03%

4.27%

If this is an independent project, the IRR method states that the firm should   .

If the project’s cost of capital were to increase, how would that affect the IRR?

The IRR would increase.

The IRR would decrease.

The IRR would not change.

Answer 1

Answer a.

Cash Flows:
Year 0 = -$1,600,000
Year 1 = $375,000
Year 2 = $500,000
Year 3 = $450,000
Year 4 = $475,000

Let IRR be i%

NPV = -$1,600,000 + $375,000/(1+i) + $500,000/(1+i)^2 + $450,000/(1+i)^3 + $475,000/(1+i)^4
0 = -$1,600,000 + $375,000/(1+i) + $500,000/(1+i)^2 + $450,000/(1+i)^3 + $475,000/(1+i)^4

Using financial calculator, i = 4.74%

Internal Rate of Return = 4.74%

Answer b.

If this is an independent project, the IRR method states that the firm should not accept Project Delta.

Answer c.

If the project’s cost of capital were to increase, the IRR would not change.