4. Internal rate of return (IRR) Aa Aa The internal rate of return (IRR) refers

Question

4. Internal rate of return (IRR) Aa Aa 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: Free Spirit Industries is evaluating a proposed capital budgeting project (project Delta) that will require an initial investment of $1,500,000. Free Spirit Industries 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. Free Spirit Industries'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 Delta's IRR? Year Cash Flow Year 1 $275,000 Year 2 $400,000 Year 3 $500,000 Year 4 $400,000 O 1.58% O 2.14% O 1.86% 1.67%

Explanation / Answer

IRR can be computed using IRR function on a calculator or excel

CF0 = -1,500,000, CF1 = 275,000...CF4 = 400,000 => Compute IRR = 1.86%

The firm should not invest because IRR < WACC

IRR doesn't change because of change in cost of capital.

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