Question

3. Understanding the IRR and NPV Aa Aa The net present value (NPV) and intemal rate of return (IRR) methods of investment analysis are interrelated and are sometimes used together to make capital budgeting decisions. Consider the case of Cold Goose Metal Works Inc. Last Tuesday, Cold Goose Metal Works 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 13.2%, but he cant recall how much Cold Goose 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: Pe Year Cash Flow Year 1 $1,600,000 Year 2 $3,000,000 Year 3 $3,000,000 Year 4 $3,000,000 The CFO has asked you to compute Project Zeta'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 Zeta is the same as that exhibited by the companys average project, which means that Project Zeta's net cash flows can be discounted using Cold Goose's 1096 WACC. Given the data and hints, Project Zeta's initial investment is to the nearest whole dollar). , and its NPV is (rounded A project's IRR will stay the same if the project's cash inflows decrease, and everything else is unaffected stay the same increase decrease

Answer 1

Calculation of Initial Investment:

Cash Flows:

Year 1 = $1,600,000
Year 2 = $3,000,000
Year 3 = $3,000,000
Year 4 = $3,000,000

IRR = 13.2%

NPV = -Initial Investment + Present Value of Cash Inflows
0 = -Initial Investment + Present Value of Cash Inflows at IRR
Initial Investment = $1,600,000/1.132 + $3,000,000/1.132^2 + $3,000,000/1.132^3 + $3,000,000/1.132^4
Initial Investment = $7,649,710

Calculation of NPV:

WACC = 10%

NPV = -$7,649,710 + $1,600,000/1.10 + $3,000,000/1.10^2 + $3,000,000/1.10^3 + $3,000,000/1.10^4
NPV = $587,159

Given the data and hints, Project Zeta’s initial investment is $7,649,710 and its NPV is $587,159

A project’s IRR will decrease if the project’s cash inflows decrease, and every else is unaffected.