Chapter 11 2. Internal rate of return (IRR) The internal rate of return (IRR) re

Question

Chapter 11 2. Internal rate of return (IRR) 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 the case of Blue Pencil Publishing: Consider the following case: Blue Pencil Publishing is evaluating a proposed capital budgeting project (project Sigma) that will require an initial investment of $850,000. Blue Pencil Publishing has been basing capital budgeting decisions on a project's NPV; however, its new CO 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 Pencil Publishing's WACC is 8%, 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 Flovw Year 1 $275,000 Year 2 $400,000 Year 3 $450,000 Year 4 $425,000 21.48% O 26.85% 25.51% 24.17% If this is an independent pro ject, the IRR method states that the firm should If mutualy exclusive projects are proposod that both have an IRR greater than the necessary WACC states that the firm should accept: the IRR method The project with the greatest IRR, assuming that both projects have the same risk as the firm's average project överage project firm's average project O The project with the greater ure cash inflows, assuming that both projects have the same risk as the firm's inflows, assum O The project that requires the lowest initial investment, assuming that both MacBook Air

Explanation / Answer

IRR = 26.85% option 2

Answer 2)

Option a) The project with the greatest IRR,assuming that both projects have the same risk as the firm's average project.

Cash flow PV( cash Flow) Y0 ($850,000.00) Y1 $275,000.00 216791.486 y2 $400,000.00 248587.3635 y3 $450,000.00 220465.7343 y4 $425,000.00 164144.7678 NPV ($0.65)=$ 0 IRR 26.850%

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