Question

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: Grey Fox Aviation Company is evaluating a proposed capital budgeting project (project Delta) that will require an initial investment of $1,500,000. Grey Fox Aviation 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 percentages and returns are easier to understand and to compare to required returns. Grey Fox Aviation Company's WACC is 7%, 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 Year 1 Year 2 Year 3 Year 4 Cash Flow $350,000 $475,000 $400,000 $475,000 5.01% 4.01% 4.76% 4.51% 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

Let irr be x%
At irr,present value of inflows=present value of outflows.

1,500,000=350,000/1.0x+475,000/1.0x^2+400,000/1.0x^3+475000/1.0x^4

Hence x=irr=5.01%(Approx).

Hence since irr is less than WACC;project must be rejected.

IRR is independent of cost of capital and hence would be unaffected by change in cost of capital.

Hence the correct option is:

The IRR would not change.