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ID: 2515939 • Letter: M

Question

marks Window Help courses.aplia.com new york for sale "audi a5" YouTube CH8-Risk and Return Flashca Aplia: Stu Fuzzy Badger Transport Company is evaluating a proposed capital budgeting project (project Sigma) that will require an initial investment of $750,000. 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 returns in percentage form are easier to understand and compare to required returns. Fuzzy Badger Transport Company's WACC is 10%, and project Sigma 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 Sigma's IRR? Year Cash Flow Year 1 $325,000 Year 2 $450,000 Year 3 $400,000 Year 4 $475,000 36.49% ? 38.41% ? 32.65% ? 30.73% If this is an independent project, the IRR method states that the firm should reject project Sigma accept project Sigma If mutually exclusive projects are proposed that both have an IRR greater than the necessary WACC, the IRR method states that the firm should accept: O The project with the greatest IRR, assuming that both projects have the same risk as the firm's average O The project that requires the lowest initial investment, assuming that both projects have the same risk as the O The project project firm's average project with the greater future cash inflows, assuming that both projects have the same risk as the fim's average project MacBook Pro

Explanation / Answer

Solution:

Calculation of IRR

Internal Rate of Return (IRR) is a discounting rate at which Net Present Value of a proposed project is Zero. In other words, at IRR, present value of cash inflows equals to present value of cash outflows.

We can calculate the IRR by trial and error method by putting equation of each option given in the question.

Year

Cash Flow

PV factor @ 32.65%

PV of Cash Flow at 32.65%

PV factor @ 38.41%

PV of Cash Flow at 38.41%

$325,000

0.754

$245,006

0.722

$234,810

$450,000

0.568

$255,740

0.522

$234,897

$400,000

0.428

$171,371

0.377

$150,854

$475,000

0.323

$153,414

0.272

$129,427

$1,650,000

$825,530

$749,988

From the above calculation it is clear that at 38.41%, PV of Cash Flow is equal to Initial Investment $750,000

Hence, the IRR is 38.41%

Project should be selected, since the WACC of company is only 10% it means company’s weighted average cost of capital is 10% and the project IRR 38.41% is greater than WACC.

In case mutually exclusive projects, the project with the greatest IRR should be selected, assuming that both projects have the same risk as the firm’s average project.

Hence, the correct option is The project with greatest IRR, assuming that both projects have the same risk as the firm’s average project.

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