Question

Blue Pencil Publishing is evaluating a proposed capital budgeting project (project Delta) that will require an initial investment of $1,450,000. Blue Pencil Publishing 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. Blue Pencil Publishing'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: Year Year 1 Year 2 Year 3 Year 4 Cash Flow $275,000 $450,000 $475,000 $500,000 Which of the following is the correct calculation of project Delta's IRR? 5.21% O 6.13% 7.05% O 5.52% 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 not change. O The IRR would increase. The IRR would decrease.

Answer 1

1)

IRR is the rate of return that makes initial investment equal to present value of cash inflows

1,450,000 = 275,000 /(1 + r)¹ + 450,000 /(1 + r)² + 475,000 /(1 + r)³ + 500,000 /(1 + r)⁴

using trial and error method , i.e., after trying various values for R, lets try R as 6.13%

1,450,000 = 275,000 /(1 + 0.0613)¹ + 450,000 /(1 + 0.0613)² + 475,000 /(1 + 0.0613)³ + 500,000 /(1 + 0.0613)⁴

1,450,000 = 1,450,000

Therefore, IRR is 6.13%

2)

Reject

A project with IRR less than cost of capital should always be rejected

3)

The IRR would not change