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

Question

2. 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 the case of Falcon Freight: Consider the following case: Falcon Freight is evaluating a proposed capital budgeting project (project Sigma) that will require an initial investment of $750,000 Falcon Freight 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. Falcon Freight'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 32.65% 38.41% 36.49% 30.73% If this is an independent project, the IRR method states that the firm should 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 greater future cash inflows, assuming that both projects have the same risk as the firm's O The project that requires the lowest initial investment, assuming that both projects have the same risk as the O The project with the greatest IRR, assuming that both projects have the same risk as the firm's average average project firm's average project project

Explanation / Answer

IRR is the rate at which NPV = 0

NPV is calculated by discounting the cashflows

PV = C/(1+r)^n

C - Cashflow

r - Discount rate

n - years to the cashflow

NPV = -750000 + 325000/(1+IRR)^1 + 450000/(1+IRR)^2 + 400000/(1+IRR)^3 + 475000/(1+IRR)^4 = 0

By trail and error, IRR = 38.41%

b.

Since the IRR is greater than the required return of 10%, the firm should accept the project.

c.

Option 3.

In case of mutually exclusive projects,

The project with greatest IRR, should be accepted.

Related Questions

Navigate

• Browse (All)
• Browse 2
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.