Question

3. Understanding the IRR and NPV

3. Understanding the IRR and NPV Aa Aa E 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 Green Caterpillar Garden Supplies Inc.: Last Tuesday, Green Caterpillar Garden Supplies Inc. lost a portion of its planning and financial data when both its main and its backup servers crashed. The company's CFO remembers that the internal rate of return (IRR) of Project Zeta is 11.3%, but he can't recall how much Green Caterpillar originally invested in the project nor the project's net present value (NPV). However, he found a note that detailed the annual net cash flows expected to be generated by Project Zeta. They are: Year Year 1 Year 2 Year 3 Year 4 Cash Flow $1,600,000 $3,000,000 $3,000,000 $3,000,000

Answer 1

1)

IRR is the rate of return that makes initial investment equal to presnet value of cash inflows

Initial investment = 1,600,000 / (1 + 0.113)^1 + 3,000,000 / (1 + 0.113)^2 + 3,000,000 / (1 + 0.113)^3 + 3,000,000 / (1 + 0.113)^4

Initial investment = $7,990,171.54

2)

NPV = Presnet value of cash inflows - present value of cash outflows

NPV = -7,990,171.54 + 1,600,000 / (1 + 0.09)^1 + 3,000,000 / (1 + 0.09)^2 + 3,000,000 / (1 + 0.09)^3 + 3,000,000 / (1 + 0.09)^4

NPV = $444,584

3)

Increase

IF the cash inflows increase, IRR will increase.