Question

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 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 Pencil Publishing'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 Year 1 Year 2 Year 3 Year 4 Cash Flow $375,000 $500,000 $450,000 $475,000 O 29.60% 35.15% 33.30% 37.00% 0 If this is an independent project, the IRR method states that the firm should 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 with the greater future cash inflows, assuming that both projects have the same risk as the firm's average project The project with the greatest IRR, assuming that both projects have the same risk as the firm's average project The project that requires the lowest initial investment, assuming that both projects have the same risk as the firm's average project

Answer 1

Answer 1: 37.00%

А 1 Year o в Cash Flow $850,000) 375,000 500,000 450,000 475,000 2 00 von AwNH 4 37.00% 8 IRR 9

B 1 Year 20 3 1 4 2 5 3 6 4 7 8 IRR Cash Flow -850000 375000 500000 450000 475000 =IRR(B2:B6)

Answer 2:

If this is an independent project, the IRR method states that the firm should ACCEPT the project (as WACC < IRR).

Answer 3:

Correct answer is Option 2.

According to IRR rule, one should accept the project with higher IRR.