Question

Blue Llama Mining Company is evaluating a proposed capital budgeting project (project Sigma) that will require an initial investment of $800,000.

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 7%, and project Sigma has the same risk as the firm’s average project.

The project is expected to generate the following net cash flows:

Year	Cash Flow
Year 1	$275,000
Year 2	$400,000
Year 3	$500,000
Year 4	$400,000

Which of the following is the correct calculation of project Sigma’s IRR?

29.54%

26.43%

37.31%

31.09%

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 increase.

The IRR would not change.

The IRR would decrease.

Answer 1

Let irr be x%
At irr,present value of inflows=present value of outflows.

800,000=275,000/1.0x+400,000/1.0x^2+500,000/1.0x^3+400,000/1.0x^4

Hence x=irr=31.09%(Approx).

Hence since irr is greater than WACC;project must be accepted

IRR is independent of change in cost of capital.Hence IRR would be unaffected by change in cost of capital.

Hence the correct option is:

The IRR would not change.