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 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 Lambda is 13.8%, but he can't 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 Lambda. They are: Year Year 1 Year 2 Year 3 Year 4 Cash Flow $1,600,000 $3,000,000 $3,000,000 $3,000,000 The CFO has asked you to compute Project Lambda'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 Lambda is the same as that exhibited by the company's average project, which means that Project Lambda's net cash flows can be discounted using Cold Goose's 7% WACC. , and its NPV is Given the data and hints, Project Lambda'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

year pv @ 7% present value of cash inflows at 13.8% discount rate = NPV =0 At IRR, npv = 0 Calculation of initial investment: year cash flows pv @ 13.8% Present value 0 $0.00 1 $1,600,000 0.8787 $1,405,975.40 2 $3,000,000 0.7722 $2,316,523.61 $3,000,000 0.6785 $2,035,609.50 $3,000,000 0.5963 $1,788,760.54 1 cash flows $7,546,869 $1,600,000 $3,000,000 $3,000,000 $3,000,000 0.9346 0.8734 0.8163 0.7629 Present value -$7,546,869 $1,495,327 $2,620,316 $2,448,894 $2,288,686 $1,306,354 4 Initial investment $7,546,869 NPV A project's IRR will decrease if cash flows decrease