In: Finance
IRR
A project's internal rate of return (IRR) is the -Select-compound
ratediscount raterisk-free rateCorrect 1 of Item 1 that forces the
PV of its inflows to equal its cost. The IRR is an estimate of the
project's rate of return, and it is comparable to the
-Select-YTMcoupongainCorrect 2 of Item 1 on a bond. The equation
for calculating the IRR is:
CFt is the expected cash flow in Period t and cash outflows are
treated as negative cash flows. There must be a change in cash flow
signs to calculate the IRR. The IRR equation is simply the NPV
equation solved for the particular discount rate that causes NPV to
equal -Select-IRRonezeroCorrect 3 of Item 1.
The IRR calculation assumes that cash flows are reinvested at the
-Select-IRRNPVWACCCorrect 4 of Item 1. If the IRR is
-Select-lessgreaterCorrect 5 of Item 1 than the project's cost of
capital, then the project should be accepted; however, if the IRR
is less than the project's cost of capital, then the project should
be -Select-acceptedrejectedCorrect 6 of Item 1. Because of the IRR
reinvestment rate assumption, when -Select-mutually
exclusiveindependent companyCorrect 7 of Item 1 projects are
evaluated the IRR approach can lead to conflicting results from the
NPV method. Two basic conditions can lead to conflicts between NPV
and IRR: -Select-returntimingpreferenceCorrect 8 of Item 1
differences (earlier cash flows in one project vs. later cash flows
in the other project) and project size (the cost of one project is
larger than the other). When mutually exclusive projects are
considered, then the -Select-IRRNPVeitherCorrect 9 of Item 1 method
should be used to evaluate projects.
Quantitative Problem: Bellinger Industries is
considering two projects for inclusion in its capital budget, and
you have been asked to do the analysis. Both projects' after-tax
cash flows are shown on the time line below. Depreciation, salvage
values, net operating working capital requirements, and tax effects
are all included in these cash flows. Both projects have 4-year
lives, and they have risk characteristics similar to the firm's
average project. Bellinger's WACC is 10%.
0 | 1 | 2 | 3 | 4 | ||||||
Project A | -1,200 | 630 | 330 | 290 | 350 | |||||
Project B | -1,200 | 230 | 265 | 440 | 800 |
What is Project A’s IRR? Round your answer to two decimal
places.
%
What is Project B's IRR? Round your answer to two decimal
places.
%
If the projects were independent, which project(s) would be
accepted according to the IRR method?
-Select-NeitherProject AProject BBoth Projects A and BCorrect 1 of
Item 3
If the projects were mutually exclusive, which project(s) would be
accepted according to the IRR method?
-Select-Neither Project AProject BBoth Projects A and BCorrect 2 of
Item 3
Could there be a conflict with project acceptance between the NPV
and IRR approaches when projects are mutually exclusive?
-Select-YesNoCorrect 3 of Item 3
The reason is -Select-the NPV and IRR approaches use the same
reinvestment rate assumption so both approaches reach the same
project acceptance when mutually projects are considered.the NPV
and IRR approaches use different reinvestment rate assumptions so
there can be a conflict in project acceptance when mutually
exclusive projects are considered.Correct 4 of Item 3
Reinvestment at the -Select-IRRWACCCorrect 5 of Item 3 is the
superior assumption, so when mutually exclusive projects are
evaluated the -Select-NPVIRRCorrect 6 of Item 3 approach should be
used for the capital budgeting decision.