Question

The internal rate of return (IRR) refers to the compound annual rate of return that a project generates based on its up-front cost and subsequent cash flows. Consider this case:

Purple Whale Foodstuffs Inc. is evaluating a proposed capital budgeting project (project Delta) that will require an initial investment of $1,450,000.

Purple Whale Foodstuffs Inc. 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 percentages and returns are easier to understand and to compare to required returns. Purple Whale Foodstuffs Inc.’s WACC is 8%, and project Delta 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	$275,000
Year 2	$400,000
Year 3	$450,000
Year 4	$425,000

Which of the following is the correct calculation of project Delta’s IRR?

a.3.06%

b.2.42%

c.2.68%

d.2.55%

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

a. Reject Project Delta

b. Accept Project Delta

If the project’s cost of capital were to increase, how would that affect the IRR?

a. The IRR would not change.

b. The IRR would decrease.

c. The IRR would increase.

Answer 1

The correct calculation of project Delta’s IRR is d. 2.55%

IRR is internal rate of return; it measures the rate of return, which is generated internally through the cash flows. IRR calculation does not include external factors such as the cost of capital, inflation, risk free rate) etc

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

a. Reject Project Delta

As stated in the question the WACC of Purple Whale Foodstuffs Inc.’s is 8%, it means the cost of capital is 8% however as per IRR calculation the return is 2.55% thus we can see the return is significantly lower that the cost of capital. Hence the project should be rejected

If the project’s cost of capital were to increase, how would that affect the IRR?

a. The IRR would not change.

As explained above IRR calculation does not include in external factors such as cost of capital, inflation etc. If there is a change in project’s cost of capital the IRR would not be impacted, it will remain the same.