Question

Falcon Freight is evaluating a proposed capital budgeting project (project Sigma) that will require an initial investment of $900,000. 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 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 Year 1 Year 2 Year 3 Year 4 Cash Flow $325,000 $450,000 $425,000 $450,000 Which of the following is the correct calculation of project Sigma's IRR? 26.53% 27.93% 22.34% 23.74% 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 decrease. The IRR would increase. The IRR would not change.

Answer 1

IRR is the Rate at which PV of cash inflows are equal to PV of Cash Outflows.

Year	CF	PVF @27%	Disc CF	PVF @28%	Disc CF
0	$ -9,00,000.00	1.0000	$ -9,00,000.00	1.0000	$ -9,00,000.00
1	$ 3,25,000.00	0.7874	$ 2,55,905.51	0.7813	$ 2,53,906.25
2	$ 4,50,000.00	0.6200	$ 2,79,000.56	0.6104	$ 2,74,658.20
3	$ 4,25,000.00	0.4882	$ 2,07,480.73	0.4768	$ 2,02,655.79
4	$ 4,50,000.00	0.3844	$ 1,72,980.69	0.3725	$ 1,67,638.06
NPV			$     15,367.49		$      -1,141.69

IRR = Rate at which least +ve NPV + [ NPV at that Rate / Change in NPV due to 1% inc in Disc rate ] * 1%

= 27% + [ 15367.49 / 16509.18 ] * 1%

= 27% + 0.93%

= 27.93%

Project should be accepted as IRR > WACC.

Change in WACC will not affect the IRR.