Question

1) A project has the following cash flows:

Year 0 -$22,500, Year 1 $12,650, Year 2 $10,900, and Year 3 $6,500. What is the IRR of the project? Please round your answer to two decimal places.

2) Following question 1, suppose the cost of capital is 15%. Would you accept or reject the project according to the IRR criterion? Accept or Reject

3) Following questions 1 and 2, which of the following statements about the IRR rule is false?

- The IRR of the project would be higher if the cash flow in year 3 is increased to $7,500.

- The IRR of the project will remain the same as in question 1 even if the cost of capital is increased to 20%.

- The investment decision by the IRR rule will remain unchanged even if the cost of capital is increased to 20%.

- Both (B) and (C) are false.

4) OpenSeas Inc., is evaluating the purchase of a new cruise ship. The ship would cost $400 million today. OpenSeas expects annual cash flows from the new ship to be $70 million and these cash flows will last forever. The cost of capital is 16%. What is the IRR of the new cruise ship? Answer in unit of %

Answer 1

1) IRR of the Project:

Particulars	Year 0	Year 1	Year 2	Year 3	NPV in $
Project Cashflows	(22500)	12650	10900	6500	---
NPV @ 12%	(22500)	11294.64	8689.4	4626.57	2110.6
NPV @ 18% (R1)	(22500)	10720.34	7828.21	3956.1	4.65
NPV @ 18.5% (R2)	(22500)	10675.1	7762.29	3906.23	(156.37)

IRR= R1 + {NPV1 * (R2-R1)} / {NPV1-NPV2}

IRR= 18 + {4.65 * (18.5-18)} / {4.65- (156.37)}

IRR= 18.0144% or 18.01 % appx.

2) Higher IRR of the project represent the greater the amount through which it exceeds the expection of the shareholders (CoC). Higher the IRR means higher cash flows to the company.

Here Cost of capital is 15% and IRR is 18.01%. Hence the project should be accepted. It will add up the cash flows of company by 3.01% (18.01% - 15%).

3) False IRR Rule is-

<The investment decision by the IRR rule will remain unchanged even if the cost of capital is increased to 20%.>

Rational: Companies use IRR to evalute particular project's profitability and cash flows as compared to its cost of capital. If Cost of capital exceeds IRR of the project; then the project has to be re-evaluated and preferably rejected.

4) IRR is 17.5% for OpenSeas Inc. of a new cruise ship:

Particulars	Year 0	Year 'n'	NPV in $
Project Cashflows	(400)	70	--
NPV @ 17%	(400)	411.76	11.76
NPV @ 17.5%	(400)	400	0