Question

4. 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 the case of Blue Llama Mining Company: Blue Llama Mining Company is evaluating a proposed capital budgeting project (project Sigma) that will require an initial investment of $800,000. The 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 returns in percentage form are easier to understand and compare to required returns. Blue Llama Mining Company’s WACC is 8%, and project Sigma 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 $350,000 Year 2 $475,000 Year 3 $425,000 Year 4 $500,000

Which of the following is the correct calculation of project Sigma’s IRR? 30.56% 34.38% 38.20% 36.29%

If this is an independent project, the IRR method states that the firm should__________(accept or reject) project Sigma.

If mutually exclusive projects are proposed that both have an IRR greater than the necessary WACC, the IRR method states that the firm should accept:

the project with the greater future cash inflows, assuming that both projects have the same risk as the firm’s average project.

the project that requires the lowest initial investment, assuming that both projects have the same risk as the firm’s average project.

the project with the greatest IRR, assuming that both projects have the same risk as the firm’s average project.

Answer 1

Calc: