Question

Larry company is considering the purchase of an investment that has a positive net present value based on a discount rate of 12%. The internal rate of return would be: a. zero b. 12% c. greater than 12% d. Less than 12%?

Answer 1

Internal rate of return is the discount rate that makes the NPV of the project = $0
IRR tells us how high the discount rate would need to be before a project is unacceptable
“Internal” because based entirely on estimated cash flows and is independent of interest rates found elsewhere

*An investment should be accepted if its internal rate of return exceeds the required return. Otherwise, it should be rejected
Goal of IRR analysis is to find a range of discount rates for which a project is acceptable
IRR tells us the discount rate that makes the project simply break even (NPV=$0)
Remember: A decrease in the discount rate increases the present value of future cash flows
Thus, if the actual discount rate (or required return) is less than the IRR, then the project will create value

*Decision Criteria Test: Satisfied
Decision rule adjusts for the time value of money
Decision rule adjusts for risk
Decision rule provides information on whether we are creating value for the firm
NPV decision rule is a candidate for our primary decision rule

Example: Computing IRR

You are looking at a new project and you have estimated the following cash flows and net income:
Year 0: CF = -165,000
Year 1: CF = 63,120; NI = 13,620
Year 2: CF = 70,800; NI = 3,300
Year 3: CF = 91,080; NI = 29,100
Your required return for assets of this risk is 12%
The average book value of the project is 72,000

Single Period Projects

Suppose a project costs $100 today and has an estimated cash flow of $110 next year
If the required return is 12%, should we accept this project based on the IRR decision rule?
Find the discount rate that sets NPV = $0
NPV = -$100 + $110 / (1+r) = $0
r = 110 / 100 – 1 = 10%
IRR = 10%
Since IRR < required return → Reject project