Question

Blue Llama Mining Company is evaluating a proposed capital budgeting project (project Sigma) that will require an initial investment of $800,000. 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 7%, 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 $275,000 $400,000 $500,000 $400,000 Which of the following is the correct calculation of project Sigma's IRR? 34.20% 37.31% 24.87% 31.09%

Answer 1

Solution: a) IRR by trial and error method Year 1 0 cash flow Discount factor at 20% PV at 20% Discount factor at 30% PV at 30% Discount factor at 31% PV at 31% c=a*b d e=a*d d e=a*d -800000.00 1.00000-800000.00 1.00000-800000.00 1.00000-800000.00 1 275000.00 0.83333 229166.67 0.76923211538.46 0.76336 209923.66 2 400000.00 0.69444 277777.78 0.59172 236686.39 0.58272 233086.65 3 500000.00 0.57870 289351.85 0.45517 227583.07 0.44482 222410.93 4 400000.00 0.48225 192901.23 0.35013140051.12 0.33956135823.47 189197.53 NPV 15859.04 NPV 1244.71 NPV By interpolation IRRE 30+(15859.04/(15859.04-1244.71)) 31.09% b) If this is an independent project, the IRR method states the firm should accept the project. as IRR is higher than required return. if the projects cost of capital were to increase, how would that affect the IRR? The IRR would not change.