Question

Your boss, the chief financial officer (CFO) for Southern Textiles, has just handed you the
estimated cash flows for two proposed projects. Project L involves adding a new item to the firm’s
fabric line. It would take some time to build up the market for this product, so the cash inflows
would increase over time. Project S involves an add-on to an existing line, and its cash flows
would decrease over time. Both projects have 3-year lives because Southern is planning to introduce
an entirely new fabric at that time.
Here are the net cash flow estimates (in thousands of dollars):

Expected Net Cash Flows Year Project L Project S
0 $(100) $(100)

1 10 70

2 60 50

3 80 20

The CFO also made subjective risk assessments of each project, and he concluded that the projects
both have risk characteristics that are similar to the firm’s average project. Southern’s required
rate of return is
10%. You must now determine whether one or both of the projects should be accepted.

e. (2) Define the term internal rate of return (IRR). What is each project’s IRR?

Answer 1

The IRR is the internal rate of return. The IRR is the discount rate at makes the NPV of a project zero. It is a measure of capital budgeting and is used to evaluate the profitability of a project.

The IRR of project A :

CFO = ($100)

CF1= $10

CF2= $60

CF3= $80

($100 ) + $10/(1+ IRR)^1 + $60/(1 + IRR)^2 + $80/(1 + IRR)^3 = 0

The IRR is 18.13%

Similarly, the IRR of project B is,

= 23.56%

So, the project with the higher IRR is the project that should be accepted. The IRR of both the projects > cost of capital hence both projects can be accepted but if we have a choice between the projects we shall choose the one which the higher IRR.