Question

3. Understanding the IRR and NPV Aa Aa E The net present value (NPV) and internal rate of return (IRR) methods of investment analysis are interrelated and are sometimes used together to make capital budgeting decisions. Consider the case of Fuzzy Button Clothing Company: Last Tuesday, Fuzzy Button Clothing Company 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 Gamma is 13.8%, but he can't recall how much Fuzzy Button 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 Gamma. They are: Year Cash Flow Year 1 Year 2 Year 3 Year 4 $1,800,000 $3,375,000 $3,375,000 $3,375,000 The CFO has asked you to compute Project Gamma'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 Gamma is the same as that exhibited by the company's average project, which means that Project Gamma's net cash flows can be discounted using Fuzzy Button's 10% WACC. , and its NPV is Given the data and hints, Project Gamma's initial investment is (rounded to the nearest whole dollar). A project's IRR will if the project's cash inflows decrease, and everything else is unaffected.

Answer 1

1)

IRR is the rate of return that makes initial investment equal to present value of cash inflows

Initial investment = 1,800,000 / (1 + 0.138)¹ + 3,375,000 / (1 + 0.138)¹ + 3,375,000 / (1 + 0.138)¹ + 3,375,000 / (1 + 0.138)⁴

Initial investment = $8,490,227.68

2)

NPV = Present value of cash inflows - present value of cash outflows

NPV = -8,490,227.68 + 1,800,000 / (1 + 0.1)¹ + 3,375,000 / (1 + 0.1)¹ + 3,375,000 / (1 + 0.1)¹ + 3,375,000 / (1 + 0.1)⁴

NPV = $776,250.02

3)

Decrease