Question

Company X is evaluating a proposed capital budgeting project (project Sigma) that will require an initial investment of $850,000. Company X 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 returns in percentage form are easier to understand and compare to required returns. Blue Llama Mining Company's WACC is 9%, and project Sigma 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 $375,000

Year 2 $500,000

Year 3 $450,000

Year 4 $475,000

a. The correct calculation of the project sigma's IRR is ....?

b. If this is an independent project, the IRR method states that the firm should ______________.

reject project Sigma .

accept project Sigma

b. If mutually exclusive projects are propsed that both have an IRR greater than the necessary WACC, the IRR method states that the firm should accept: .

The project with the greatest IRR, assuming that both projects have the same risk as the firm's average project .

The project that requires the lowest initial investment, assuming that both projects have the same risk as the firm's average project .

The project with the greater cash inflows, assuming that both projects have the same risk as the firm's average project

Answer 1

A. IRR is the rate at which NPV becomes zero, it will be calculated by hit and trail method.

First try the NPV at 9%

Year	0	1	2	3	4
Cash Flow	(850,000.00)	375,000.00	500,000.00	450,000.00	475,000.00
Required rate	0.09
Discount factor= 1/(1+r)^n	1.00	0.9174	0.8417	0.7722	0.7084
Present Value= Cash flow * Discount Factor	(850,000.00)	344036.697	420839.997	347482.566	336501.9753
NPV= sum of allthe present values	598,861.24

The NPVis very much on positive side to make it zero, lets try with 35%

Year	0	1	2	3	4
Cash Flow	(850,000.00)	375,000.00	500,000.00	450,000.00	475,000.00
Required rate	0.35
Discount factor= 1/(1+r)^n	1.00	0.7407	0.5487	0.4064	0.3011
Present Value= Cash flow * Discount Factor	(850,000.00)	277777.778	274348.422	182898.948	143007.4082
NPV= sum of allthe present values	28,032.56

NPV is still positive.

LetsTry with 37%

Year	0	1	2	3	4
Cash Flow	(850,000.00)	375,000.00	500,000.00	450,000.00	475,000.00
Required rate	0.37
Discount factor= 1/(1+r)^n	1.00	0.7299	0.5328	0.3889	0.2839
Present Value= Cash flow * Discount Factor	(850,000.00)	273722.628	266396.718	175005.143	134837.7016
NPV= sum of allthe present values	(37.81)

Now the NPV is close to zero so IRR will be 37%

b) The Firm should accept the project as IRR is way higher than required rate

C)The project with the greatest IRR, assuming that both projects have the same risk as the firm's average project