Question

2. Internal rate of return (IRR)

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 the case of Blue Llama Mining Company:

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	$300,000
Year 2	$425,000
Year 3	$475,000
Year 4	$450,000

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

23.18%

27.27%

24.54%

30.00%

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 increase.

The IRR would not change.

The IRR would decrease.

Answer 1

a). To find the IRR, we need to put the following values in the financial calculator:

CF0 = -900,000; C01 = 300,000; F01 = 1; C02 = 425,000; F02 = 1; C03 = 475,000; F03 = 1; C04 = 450,000; F04 = 1;

Press IRR, then CPT, which gives us 27.27

IRR = 27.27%

So, 2nd option is correct.

b). According to IRR method, the project should be accepted as its IRR is greater than its cost of capital.

c). IRR has no relation with the cost of capital so it will not change.

2nd option is correct.