Question

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 9%, 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 $350,000

Year 2 $475,000

Year 3 $425,000

Year 4 $500,000

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

3.17%

3.87%

2.99%

3.52%

If this is an independent project, the IRR method states that the firm should . Accept project Delta OR Reject project Delta?

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

The IRR would increase.

The IRR would not change.

The IRR would decrease.

Can you answer this on Excel please

Answer 1

Solution

Now, to find IRR, IRR is the discount rate at which NPV=0.

Where:

t =each period

T= holding period

r= Discount rate

C0= Initial investment

Ct= Cash flow in each period

IRR can be calculated through excel too. Calculation Given below

Thus IRR= 3.52%

Excel formula

Since the IRR= 3.52% is less than WACC= 9%, therefore, the project Delta should be rejected

If the project's cost of capital increases it will have no impact on IRR as it is a hurdle rate and does not change due to changes in the cost of capital, thus IRR would not change

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