Question

Purple Whale Foodstuffs Inc. is evaluating a proposed capital budgeting project (project Delta) that will require an initial investment of $1,500,000 Purple Whale Foodstuffs Inc. 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. Purple Whale Foodstuffs Inc.'s WACC is 7%, 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 Year 1 Year 2 Year 3 Year 4 Cash Flow $325,000 $450,000 $400,000 $475,000 Which of the following is the correct calculation of project Delta's IRR? 3.74% 4.11% 4.30% 3.18% 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 not change. The IRR would decrease. The IRR would increase.

Answer 1

Initial Investment

The question has given he Internal Rate of Return [IRR] as 13.20%, IRR is the rate at which the present value of the annual cash flow equals to the initial Investment or it can say that at IRR, the present value of the annual cash flow = Initial Investment, or at IRR, NPV will be Zero

Initial Investment = Present Value of the annual cash inflows discounted at 13.80%

Year	Annual Cash Flow	Present Value factor at 13.20%	Present Value of Cash Flow
1	24,00,000	0.8833922	21,20,141
2	45,00,000	0.7803818	35,11,718
3	45,00,000	0.6893832	31,02,225
4	45,00,000	0.6089958	27,40,481
TOTAL			11,474,565

“Therefore, the Initial Investment is $11,474,565”

Net Present Value (NPV)

Year	Annual Cash Flow	Present Value factor at 9.00%	Present Value of Cash Flow
1	24,00,000	0.9174312	22,01,835
2	45,00,000	0.8416800	37,87,560
3	45,00,000	0.7721835	34,74,826
4	45,00,000	0.7084252	31,87,913
TOTAL			12,652,134

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $12,652,134 - $11,474,565

= $1,177,569

“The Net Present Value (NPV) will be $1,177,569”

“Given the data and hints, Project Gamma’s Initial Investment is $11,474,565 and it’s NPV is $1,177,569”

A Project’s IRR will “DECREASE” if the Project’s cash flows decreases, and everything else is unaffected.

NOTE    

The Formula for calculating the Present Value Factor is [1/(1 + r)ⁿ], Where “r” is the Discount/Interest Rate and “n” is the number of years.