Question

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:

Falcon Freight is evaluating a proposed capital budgeting project (project Delta) that will require an initial investment of $1,500,000.

Falcon Freight 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. Falcon Freight’s WACC is 7%, 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	$325,000
Year 2	$450,000
Year 3	$400,000
Year 4	$475,000

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

3.18%

4.30%

4.49%

3.74%

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?

a) The IRR would decrease.

b) The IRR would increase.

c) The IRR would not change.

Answer 1

1)

IRR is the rate of return that makes initial investment equal to present value of cash inflows

1,500,000 = 325,000 / (1 + r)^1 + 450,000 / (1 + r)^2 + 400,000 / (1 + r)^3 + 475,000 / (1 + r)^4

Using trial and error method, i.e. after trying various values for R, lets try R as 3.74%. Or you can pick from the options given. It will save a lot of time

1,500,000 = 325,000 / (1 + 0.0374)^1 + 450,000 / (1 + 0.0374)^2 + 400,000 / (1 + 0.0374)^3 + 475,000 / (1 + 0.0374)^4

1,500,000 = 1,500,000

Therefore, IRR is 3.74%

2)

Reject

Any project having IRR less than WACC should be rejected.

3)

c) The IRR would not change.

Cost of capital does not affect IRR.