Question

Suppose your firm is considering investing in Project Q with the cash flows shown in the table. Assume that the required rate of return on projects of this risk class is 10.5 percent, and that the maximum allowable payback and discounted payback statistics for the project are 3.5 and 4.5 years, respectively. Use the IRR decision to evaluate this project; should it be accepted or rejected? A. IRR = 18.32%; accept the project B. IRR = 16.46%; accept the project C. IRR = 12.64%; accept the project D. IRR = 8.12%; reject the project E. IRR = 7.59%; reject the project

Answer 1

If the project has only positive cash flows after the initial negative cash flows (in the form of the initial investment), then the project's NPV vs discount rate curve is downward sloping. In other words, if the sign of the project cash flows change only once, then the project NPV is non-linearly indirectly related to the project's discount rate.

In such a scenario, the project NPV decreases (approaches zero or the x-axis) as the discount rate increases and at the project IRR the project NPV becomes zero (the NPV vs discount rate curves intersects the x-axis at discount rate = IRR). Hence, any discount rate lower than the IRR (discount rate lower and hence to the left of the IRR on the x-axis) will generate positive project NPV, thereby being acceptable. In the context given, the discount rate of 10.5 % is lower than (and hence to the left of) (A) IRR = 18.32%, (B) IRR = 16.46% and (C) IRR = 12.64%.

Therefore, the unacceptable IRRs are (D) IRR = 8.12% and (E) IRR = 7.59%