Question

7. The IRR on the new investment is 12%, and the project can be 100% debt-financed through risk-free debt where the bondholders require a 9% rate of return. The company should therefore proceed with the investment. Do you agree, disagree, or unable to determine? Why? Explain.

Answer 1

The internal rate of return is one of the method to evaluate the decision on whether project should be accepted or rejected. As per the internal rate of return decision rule if a project has internal rate of return higher than its cost of capital then the project should be accepted. In this case the project is 100% financed through debt which has cost of capital of 9% that is return expected by bondholders. The Internal rate of return is 12% which is more than the cost of capital of 9% and therefore the project should be accepted for investment. The higher the internal rate of return, higher is the profitability from the project. The project is providing higher return then the cost of financing and so the project should be accepted.

Therefore, in this case the company should proceed with the investment in the project.