Question

Consider the following three projects:

Project/time line	0	1	2	3	4
A	-95	50	40	40	0
B	-115	35	40	45	50
C	-125	60	60	60	-20

The cost of capital of the firm is 10%.

Based on the IRR decision rule:

1. Should you invest in Project A?

Below are multiple choice for the IRR calculation

i) 16.55%

ii) 17.61%

iii) 18.31%

iv) 20.22%

v) Cannot calculate

Answer: I should/should not (choose one) invest in Project A.

2. Should you invest in Project B?

Below are multiple choice for the IRR calculation

i) 16.55%

ii) 17.61%

iii) 18.31%

iv) 20.22%

v) Cannot calculate

Answer: I should/should not (choose one) invest in Project B.

3. Should you invest in Project C?

Below are multiple choice for the IRR calculation

i) 16.55%

ii) 17.61%

iii) 18.31%

iv) 20.22%

v) Cannot calculate

Answer: I should/should not (circle one) invest in Project C.

4. Assume that we can only take one of the projects. Which one would we choose?

Answer: You would choose project ____________

Answer 1

The Internal Rate of Return (IRR) is a measure of annualized rate of return for an investment. IRR is essentially that rate of return where the Net Present Value (NPV) of a project is zero. IRR is computed using the following algebraic formula:

where CF represent the cash flows in different years.

IRR can be calculated using the IRR or XIRR function in an excel spreadsheet or using a financial calculator. An approximation of IRR can be obtained manually using trial and error.

The IRRs for projects A, B and C are as follows:

Project	IRR
A	18.31%
B	16.55%
C	15.30%

IRR Decision Rule: An investment is economically feasible if its IRR exceeds the firm's cost of capital as the NPV would be positive in this case and the shareholder's wealth will increase.

1. Correct Option - iii)

I should invest in project A as the IRR is higher than the cost of capital.

2. Correct Option - i)

I should invest in project B as the IRR is higher than the cost of capital.

3. Correct Option - None

I should invest in project C as the IRR is higher than the cost of capital.

4. If one one of the project could be chosen then the firm should go with Project A as it has the highest IRR among the three.