Question

Cutler Petroleum, Inc., is trying to evaluate a generation project with the following cash flows:

Year Cash Flow
0 –$ 85,000,000
1 125,000,000
2 – 15,000,000

A. If the company requires a 10% return on its investment should it accept this project? Why?

b.Compare the project IRR for this project. How many IRRs are there? If you should apply the IRR division rule. Should you accept the project or not.? What's going on here?

Answer 1

Years	Cash Flows	PV
0	-85,000,000	(85,000,000)
1	125,000,000	113,636,364
2	-15,000,000	(12,396,694)
Expeteted return	10%
NPV	16,239,669
IRR	33.88%

a)

NPV = PV of all the cash flows

PV of cash flow at time n = Cash flow at time n/ ((1+r)^n)

NPV = 16,239,669

On the basis of NPV we will accept the project as NPV is more than 0.

b)

IRR is the interest rate at which NPV = 0

There will be total of 2 IRRs.

0 = -CF0 + (CF1/((1+IRR)^1)) + (CF2/((1+IRR)^2))

IRR = 33.88%

We would accept the project as the IRR is greater than the required return.

Here, IRR will be a misleading Capital Budgeting criteria as there are multiple IRRs.