Question

The Basics of Capital Budgeting: IRR

IRR A project's internal rate of return (IRR) is the (Select: compound rate, discount rate, or risk-ree rate) that forces the PV of its inflows to equal its cost. The IRR is an estimate of the project's rate of return, and it is comparable to the (Select: YTM, Coupon, gain) on a bond.

CF_t is the expected cash flow in Period t and cash outflows are treated as negative cash flows. There must be a change in cash flow signs to calculate the IRR. The IRR equation is simply the NPV equation solved for the particular discount rate that causes NPV to equal (Select: IRR, one, zero)

The IRR calculation assumes that cash flows are reinvested at the (Select: IRR, NPV, WACC). If the IRR is (Select: less, greater) Correct 5 of Item 1 than the project's risk-adjusted cost of capital, then the project should be accepted; however, if the IRR is less than the project's risk-adjusted cost of capital, then the project should be (Select: accepted, rejected). Because of the IRR reinvestment rate assumption, when (Select: mutually exclusive, independent) projects are evaluated the IRR approach can lead to conflicting results from the NPV method. Two basic conditions can lead to conflicts between NPV and IRR: (Select: return, timing, preference) differences (earlier cash flows in one project vs. later cash flows in the other project) and project size (the cost of one project is larger than the other). When mutually exclusive projects are considered, then the (Select: IRR, NPV) method should be used to evaluate projects.

Answer 1

IRR A project's internal rate of return (IRR) is the discount rate that forces the PV of its inflows to equal its cost. The IRR is an estimate of the project's rate of return, and it is comparable to the YTM on a bond.

CF_t is the expected cash flow in Period t and cash outflows are treated as negative cash flows. There must be a change in cash flow signs to calculate the IRR. The IRR equation is simply the NPV equation solved for the particular discount rate that causes NPV to equal zero

The IRR calculation assumes that cash flows are reinvested at the IRR

If the IRR is greater Correct 5 of Item 1 than the project's risk-adjusted cost of capital, then the project should be accepted; however, if the IRR is less than the project's risk-adjusted cost of capital, then the project should be rejected

Because of the IRR reinvestment rate assumption, when mutually exclusive projects are evaluated the IRR approach can lead to conflicting results from the NPV method.

Two basic conditions can lead to conflicts between NPV and IRR: timing differences (earlier cash flows in one project vs. later cash flows in the other project) and project size (the cost of one project is larger than the other). When mutually exclusive projects are considered, then the NPV method should be used to evaluate projects.