Capital Budgeting Decision Criteria: IRR IRR A project\'s internal rate of retur
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Capital Budgeting Decision Criteria: IRR
IRR
A project's internal rate of return (IRR) is the -Select-compound ratediscount raterisk-free rateCorrect 1 of Item 1 that forces the PV of its inflows to equal its cost. The IRR is an estimate of the project's rate of return, and it is comparable to the -Select-YTMcoupongainCorrect 2 of Item 1 on a bond. The equation for calculating the IRR is:
CFt is the expected cash flow in Period t and cash outflows are treated as negative cash flows. There must be a change in cash flow signs to calculate the IRR. The IRR equation is simply the NPV equation solved for the particular discount rate that causes NPV to equal -Select-IRRonezeroCorrect 3 of Item 1.
The IRR calculation assumes that cash flows are reinvested at the -Select-IRRNPVWACCCorrect 4 of Item 1. If the IRR is -Select-lessgreaterCorrect 5 of Item 1 than the project's cost of capital, then the project should be accepted; however, if the IRR is less than the project's cost of capital, then the project should be -Select-acceptedrejectedCorrect 6 of Item 1. Because of the IRR reinvestment rate assumption, when -Select-mutually exclusiveindependent companyCorrect 7 of Item 1 projects are evaluated the IRR approach can lead to conflicting results from the NPV method. Two basic conditions can lead to conflicts between NPV and IRR: -Select-returntimingpreferenceCorrect 8 of Item 1 differences (earlier cash flows in one project vs. later cash flows in the other project) and project size (the cost of one project is larger than the other). When mutually exclusive projects are considered, then the -Select-IRRNPVeitherCorrect 9 of Item 1 method should be used to evaluate projects.
Quantitative Problem: Bellinger Industries is considering two projects for inclusion in its capital budget, and you have been asked to do the analysis. Both projects' after-tax cash flows are shown on the time line below. Depreciation, salvage values, net operating working capital requirements, and tax effects are all included in these cash flows. Both projects have 4-year lives, and they have risk characteristics similar to the firm's average project. Bellinger's WACC is 10%.
What is Project A
0 1 2 3 4 Project A -1,100 600 380 270 340 Project B -1,100 200 315 420 790Explanation / Answer
Project-A PV@10% Cash Outflow -1100 -1100 Cash Inflow 600 545.45 380 314.05 270 202.85 340 232.22 NPV=Sum of PV of Cash flow 194.58 IRR 8% Project-B -1100 -1100 Cash Outflow 200 181.82 Cash Inflow 315 260.33 420 315.55 790 539.58 NPV=Sum of PV of Cash flow 197.28 IRR 6% Neither projects can be selected as the IRRsRelated Questions
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