IRR IRR and NPV Blue Llama Mining Company is evaluating a proposed capital budge
ID: 2562797 • Letter: I
Question
IRR
IRR and NPV
Blue Llama Mining Company is evaluating a proposed capital budgeting project (project Sigma) that will require an initial investment of $900,000 Blue Llama Mining 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 returns in percentage form are easier to understand and compare to required returns. Blue Llama Mining Company's WACC is 9%, and project Sigma 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 Sigma's IRR? Year Cash Flow Year 1 $325,000 Year 2 $450,000 Year 3 $425,000 Year 4 $450,000 O 26.53% 22.34% 23.74% O 27.9396 If this is an independent project, the IRR method states that the firm should accept project Sigma reject project Sigma If mutually exclusive projects are proposed that both have an IRR greater than the necessary WACC, the IRR method states that the firm should accept O The project that requires the lowest initial investment, assuming that both projects have the same risk as the O The project with the greater future cash inflows, assuming that both projects have the same risk as the firm's O The project with the greatest IRR, assuming that both projects have the same risk as the firm's average firm's average project average project projectExplanation / Answer
BLUE LLAMA MINING COMPANY: 1) IRR is that discount rate for which NPV = 0.This has to be found out by trial and error. Year Cash flows PVIF at 27% PV at 27% PVIF at 28% PV at 28% 0 -900000 1.00000 -900000 1.00000 -900000 1 325000 0.78740 255906 0.78125 253906 2 450000 0.62000 279001 0.61035 274658 3 425000 0.48819 207481 0.47684 202656 4 450000 0.38440 172981 0.37253 167638 15367 -1142 NPV is positive for 27% and negative for 28%. Hence, IRR must lie between 27% and 28%. It can be found out by simple interpolation as below" IRR = 27 + 15367/(15367+1142) = 27.93% Answer 2) If this is an independent project, the IRR method states that the should Accept Project Sigma. (as the IRR>than the WACC of 9%) 3) If mutuall exclusive projects are proposed………………………………………..the firm should accept: *The project with the greatest IRR, assuming that both projects have the same risk as the firm's average project. GREEN CATERPILLAR GARDEN SUPPLIES INC: 1) Year Cash flow PVIF at 14.6% PV at 14.6% 1 2200000 0.87260 1919721 2 4125000 0.76143 3140904 3 4125000 0.66443 2740754 4 4125000 0.57978 2391583 INITITAL INVESTMENT = 10192963 Answer 2) NPV: Year Cash flow PVIF at 8% PV at 8% 1 2200000 0.92593 2037037 2 4125000 0.85734 3536523 3 4125000 0.79383 3274558 4 4125000 0.73503 3031998 PV of cash inflows = 11880116 Less: Initial investment 10192963 NPV 1687153 Given the data and hints, Project Omicron's initial investment is $10,192,963 and its NPV is $1,687,153 3) A projects IRR will decrease if the project's cash flows decrease, and every thing else is unaffected.
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