Question

"X"Company, is confronted with six projects competing for its fixed budget $250.000 the initial investment and IRR for each project are as follows:
Project
Initial Investment     IRR             Present        Value of cash inflow at 10%
A                           $ 80,000              12%                    100,000
B                              70,000               20%                   112,000

C                            100,000              16%                   145,000

 

D                            40,000                 8%                   36,000

 

E                            60,000                15%                   79,000

 

F                            110,000              11%                   126,500

Knowing that the firm cost of capital is 10%
REQUIRED
Recommend the company which project should be acceptable according to IRR approach; discuss the rational of using the IRR method.

Answer 1

As per IRR approach, the project is recommended to be acceptable if the IRR is greater than the cost of capital. In case there are two or more projects and the decision is to be made among them, then the project with the highest IRR should be accepted.

 

In the given projects, all the projects except Project D have greater IRR than Cost of capital. Hence the project with the highest IRR should be selected. Project B is acceptable as it has the highest IRR, 20% and is greater than the cost of capital, 10%.

 

Rationale:

IRR, Internal Rate of Return, is the return which is derivable from the project. Cost of Capital is the minimum rate of return. If IRR is greater than the cost of capital, then the project is able to give more than the expected minimum return.

 

Hence the project should be accepted if the IRR is more than the cost of capital. In case, there are more than one project with IRR greater than cost of capital, the project with the highest IRR should be accepted as it gives the highest return.

As per IRR approach, the project is recommended to be acceptable if the IRR is greater than the cost of capital.