Question

Suppose a project requires an initial cash outflow of $34,900. The project will last for four years with the annual cash flows given below. The required rate of return is 12%.

Year	Cash Flow
1	12,500
2	19,700
3	0
4	10,400

A) Compute the net present value of the project. Should the firm invest in this project based on net present value? Why?

B) Compute the internal rate of return. Should the firm invest in this project based on internal rate of return? Why?

C) Use a graph to show why the firm’s decisions in (1) and (2) are consistent or inconsistent. Be specific

D) Now suppose another project’s future annual cash flows are given below with an initial cash outflow $14,900.00). The required rate of return is 12%. Using a graph to explain why you cannot use IRR for capital budgeting in this case. (You do not need to compute anything here.)

Year	Cash Flow
1	12,500
2	12,500
3	12,500
4	12,500
5	12,500
6	12,500
7	-19,700
8	-20,000
9	-20,000
10	-20,000

Answer 1

Part C> Values of Part A and B can be plotted on a graph to understand it better.

Part D>

If we calculate the NPV for different rate of returns, we can see from the graph that the value of NPV comes out to be zero at two different rates. It means there are two values of IRR that makes NPV zero. This usually happens when there are non-conventional cash flow as it is in our case. Hence IRR cannot be used in this case.

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