Question

Blue Llama Mining Company is evaluating a proposed capital budgeting project (project Sigma) that will require an initial investment of $900,000.

Blue Llama Mining 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. Blue Llama Mining Company’s WACC is 9%, and project Sigma has the same risk as the firm’s average project.

The project is expected to generate the following net cash flows:

Year	Cash Flow
Year 1	$325,000
Year 2	$450,000
Year 3	$425,000
Year 4	$450,000

Which of the following is the correct calculation of project Sigma’s IRR?

22.34%

26.53%

29.33%

27.93%

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.

The IRR would decrease.

The IRR would increase.

Answer 1

The IRR of the project can be computed as :

CF0 = ($9,00,000)

CF1 = $325,000

CF2 = $4,50,000

CF3 = $425,000

CF4= $4,50,000

So, the IRR is the rate at which the NPV is zero,

The IRR is :

($9,00,000) + $3,25,000/ (1 + IRR)^1 + $4,50,000/ (1 + IRR)^2 + $4,25,000/ (1 + IRR)^3 + $4,50,000/ (1 + IRR)^4= 0

So, the IRR = 27.93%

SO, the correct option is option D.

Yes, if this project is an independent project, then according to the IRR rule this project should be accepted as the IRR is greater than the cost of capital.

The IRR assumes that the cash flows are reinvested at the IRR and not at the cost of capital, hence if the cost of capital changes it will have no effect on the IRR.

So, the correct option is option A.