Question

The net present value (NPV) and internal rate of return (IRR) methods of investment analysis are interrelated and are sometimes used together to 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 its server and its backup server crashed. The company’s CFO remembers that the internal rate of return (IRR) of Project Gamma is 11.30%, but he can’t recall how much Blue Hamster originally invested in the project nor the project’s net present value (NPV). However, he found a note that contained the annual net cash flows expected to be generated by Project Gamma. They are:

Year	Cash Flow
1	$1,800,000
2	3,375,000
3	3,375,000
4	3,375,000

The CFO has asked you to compute Project Gamma’s initial investment using the information currently available to you. He has offered the following suggestions and observations:

•	A project’s IRR represents the return the project would generate when its NPV is zero or the discounted value of its cash inflows equals the discounted value of its cash outflows—when the cash flows are discounted using the project’s IRR.
•	The level of risk exhibited by Project Gamma is the same as that exhibited by the company’s average project, which means that Project Gamma’s net cash flows can be discounted using Blue Hamster’s 7.00% desired rate of return.

Given the data and hints, Project Gamma’s initial investment is    and its NPV is (both rounded to the nearest whole dollar).

Answer 1

Initial Investment = Present Value of Cash Flows at IRR
Initial Investment = $1,800,000/1.1130 + $3,375,000/1.1130^2 + $3,375,000/1.1130^3 + $3,375,000/1.1130^4
Initial Investment = $8,988,943

WACC = 7.00%

Net Present Value = -$8,988,943 + $1,800,000/1.07 + $3,375,000/1.07^2 + $3,375,000/1.07^3 + $3,375,000/1.07^4
Net Present Value = -$8,988,943 + $9,959,875
Net Present Value = $970,932

Given the data and hints, Project Gamma’s initial investment is $8,988,943 and its NPV is $970,932