Question

3. Understanding the IRR and NPV The net present value (NPV) and internal rate of return (IRR) methods of Investment make capital budgeting decisions Consider the case of Blue Hamster Manufacturing Inc Last Tuesday, Blue Hamster Manufacturing Inc. lost a portion of its planning and financial data when both its main and servers crashed. The company's CFO remembers that the internal rate of retur (IRR) of Project Zeta is 13.8%, but he can't reca much Blue Hamster originally invested in the project nor the project's net present value (NPV). However, he found a note that deta the annual net cash flows expected to be generated by Project Zeta. They are: Year Cash Flow Year 1 Year 2 Year 3 Year 4 $1,800,000 $3,375,000 $3,375,000 $3,375,000 The CFO has asked you to compute Project Zeta's initial investment using the information currently available to you. He has offered the following suggestions and observations: • A project's Represents the return the project would generate when it NPV is zero or the discounted value of its cash inflows equals the count of h o w when the cash flows are discounted using the project's RR. • The level of by P e ts the same as that by the company's average project, which means that Zet's how can be cont a cter's 10% WACC

Answer 1

Cash Flows:
Year 1 = $1,800,000
Year 2 = $3,375,000
Year 3 = $3,375,000
Year 4 = $3,375,000

IRR = 13.80%

Initial Investment = Present Value of Cash Inflows at IRR
Initial Investment = $1,800,000/1.138 + $3,375,000/1.138^2 + $3,375,000/1.138^3 + $3,375,000/1.138^4
Initial Investment =$8,490,228

WACC = 10.00%

Net Present Value = -$8,490,228 + $1,800,000/1.10 + $3,375,000/1.10^2 + $3,375,000/1.10^3 + $3,375,000/1.10^4
Net Present Value = $776,250

Given the data and hints, Project Zeta’s initial investment is $8,490,228, and its NPV is $776,250.

A project’s IRR will increase if the project’s cash inflows increase, and everything else is unaffected.