Question

Ch 11: Assignment - The Basics of Capital Budgeting 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 this case of Blue Llama Mining Company: Blue Llama Mining Company is evaluating a proposed capital budgeting project (project Delta) that will require an initial investment of $1,450,000 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 percentages and returns are easier to understand and to compare to required returns. Blue Llama Mining Company's WACC is 10%, and project Delta has the same risk as the firm's average project. The project is expected to generate the following net cash flows: Year Cash Flow Year1 $275,000 Year 2 $400,000 Year 3 $450,000 Year 4 $425,000

Answer 1

Internal rate of return is calculated using a financial calculator by inputting the below:

• Press the CF button.
• CF0= -$1,450,000. It is entered with a negative sign since it is a cash outflow.
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the IRR and CPT button to get the IRR of the project.

The IRR of project is 2.55%.

Hence, the answer is option d.

If this is an independent project, the IRR method states that that the firm should reject the project. The reason being that the internal rate of return is lower than the weighted average cost of capital of 10%.

If the project’s cost of capital were to increase, the IRR would not change.

In case of any query, kindly comment on the solution.