Question

4. Internal rate of return (IRR) 

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: 

Consider the following case: 

Fuzzy Badger Transport Company is evaluating a proposed capital budgeting project (project Delta) that will require an initial investment of $1,500,000 

Fuzzy Badger Transport Company 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. Fuzzy Badger Transport Company'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: 

Which of the following is the correct calculation of project Cash Flow Year Delta's IRR?

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

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

The IRR would decrease. 

The IRR would not change. 

Answer 1

The IRR is calculated using the following formula:

Initial investment = C1/(1+IRR) + C2/(1+IRR)² + ......+C2/(1+IRR)^N  

where C1, C2,.. CN are the cash flows in year 1, 2,...N

N is the number of years.

substitute the given values in the equation:

1500000 = 350000/(1+IRR) + 475000/(1+IRR)² + 400000/(1+IRR)³ + 475000/(1+IRR)⁴.

This can be written as:

-1500,000 + 350000/(1+IRR) + 475000/(1+IRR)² + 400000/(1+IRR)³ + 475000/(1+IRR)⁴ =0

To solve this we either need a financial calculatore or using the IRR function in Microsoft Excel. In Excel the initial investment is entered as a negative number, because it tries to solve the above equation.

By using excel, IRR comes out to be 0.0501 = 5.01%

IRR is the internal rate of return, it only depends upon the cash flows that are generated by the initial investment and not on any other factor such as cost of capital. Hence IRR will not change even if cost of capital increase or decrease.