Blue Moose Home Builders s evaluating a proposed capital budgeting project (proj

Question

Blue Moose Home Builders s evaluating a proposed capital budgeting project (project Delta) that will require an initial investment of $1,500,000. Blue Moose Home Builders 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 Moose Home Builders? WACC is 8%, and project Delta has the same risk as the firm?s average project. The project is expected to generate the following net cash flows: Which of the following is the correct calculation of project Delta?s IRR? 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.

Explanation / Answer

Part A)

IRR is the rate of return where NPV = 0. The IRR can be calculated with the use of IRR function/formula of EXCEL/Financial Calculator. The general formula for calculation of IRR is:

NPV = 0 = Cash Flow Year 0 + Cash Flow Year 1/(1+IRR)^1 + Cash Flow Year 2/(1+IRR)^2 + Cash Flow Year 3/(1+IRR)^3 + Cash Flow Year 1/(1+IRR)^4

_____________

Calculation of IRR with the use of EXCEL:

IRR = 3.74% (which is Option C)

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Part B)

If this is an independent project, the IRR method states that the firm should reject the project.

An independent project should be accepted only if the IRR is greater than the cost of capital of the proposed project. If IRR is less than the cost of capital, the project should be rejected.

___________

Part C)

IRR would not change (which is Option A)

A change in cost of capital will not have any direct impact on the IRR. The calculation of IRR is based on the cash flows generated by the project and life of the project.

Year Cash Flow 0 -1,500,000 1 325,000 2 450,000 3 400,000 4 475,000 IRR =IRR(-1500000,325000,450000,400000,475000) = 3.74%

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