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ookmarks Window Help courses.aplia.com sed Acura TLs For Sale Near Brookyn, NY E. 2. Internal rate of return (IRR Aa Aa 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: Consider the following case: Grey Fox Aviation Company is evaluating a proposed capital budgeting project (project Delta) that will require arn initial investment of $1,600,000. Grey Fox Aviation 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. Grey Fox Aviation Company's WACC is 9%, 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? Year Cash Flow Year 1 $375,000 Year 2 $500,000 Year 3 $425,000 Year 4 $500,000 O 5.43% o 5.1996 0 5.66% o 4.72% oject Delta accept project Delta Delta If this is an independent project, the IRR method states that the firm should re reject If the project's cost of capital were to increase, how would that affect the IRR? O The IRR would not change. O The IRR would decrease. O The IRR would increase. 9 MacBook ProExplanation / Answer
Solution:
Calculation of IRR
Internal Rate of Return (IRR) is a discounting rate at which Net Present Value of a proposed project is Zero. In other words, at IRR, present value of cash inflows equals to present value of cash outflows.
We can calculate the IRR by trial and error method by putting equation of each option given in the question.
Year
Cash Flow
PV Factor @ 5.66%
PV of Cash Flow at 5.66%
PV factor @ 5.43%
PV of Cash Flow at 5.43%
PV factor @ 4.72%
PV of Cash Flow at 4.72%
1
$375,000
0.946
354912
0.948
$355,686
0.955
$358,098
2
$500,000
0.896
447866.7
0.900
$449,823
0.912
$455,943
3
$425,000
0.848
360294.1
0.853
$362,657
0.871
$370,084
4
$500,000
0.802
401169.2
0.809
$404,681
0.832
$415,768
$1,800,000
1564242
$1,572,848
$1,599,893
From the above calculation it is clear that at 4.72%, PV of Cash Flow is equal to Initial Investment $1,600,000.
Hence, the IRR is 4.72%
Project should be rejected, since the WACC of company is 9% and projects IRR is only 4.72%.
If the project’s cost of capital to increase, the IRR would decrease.
Explanation --- At present the cost of capital of project is 1,600,000 in case it is increased to 1,800,000 we need to calculate the IRR at decrease rate in order to recover the cost of capital.
Hence, the IRR would decrease
Hope the above calculations, working and explanations are clear to you and help you in understanding the concept of question.... please rate my answer...in case any doubt, post a comment and I will try to resolve the doubt ASAP…thank you
Year
Cash Flow
PV Factor @ 5.66%
PV of Cash Flow at 5.66%
PV factor @ 5.43%
PV of Cash Flow at 5.43%
PV factor @ 4.72%
PV of Cash Flow at 4.72%
1
$375,000
0.946
354912
0.948
$355,686
0.955
$358,098
2
$500,000
0.896
447866.7
0.900
$449,823
0.912
$455,943
3
$425,000
0.848
360294.1
0.853
$362,657
0.871
$370,084
4
$500,000
0.802
401169.2
0.809
$404,681
0.832
$415,768
$1,800,000
1564242
$1,572,848
$1,599,893
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