The Basics of Capital Budgeting: IRR IRR
A project's internal rate of return (IRR) is the
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compound rate
discount rate
risk-free rate
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
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YTM
coupon
gain
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
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IRR
one
zero
The IRR calculation assumes that cash flows are reinvested at the
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IRR
NPV
WACC
If the IRR is
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less
greater
than the project's risk-adjusted cost of capital, then the project should be accepted; however, if the IRR is less than the project's risk-adjusted cost of capital, then the project should be
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accepted
rejected
Because of the IRR reinvestment rate assumption, when
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mutually exclusive
independent
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:
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return
timing
preference
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
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IRR
NPV
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%.
0 1 2 3 4
Project A -1,100 600 380 270 340
Project B -1,100 200 315 420 790
What is Project A’s IRR? Do not round intermediate calculations. Round your answer to two decimal places.
%
What is Project B's IRR? Do not round intermediate calculations. Round your answer to two decimal places.
%
If the projects were independent, which project(s) would be accepted according to the IRR method?
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Neither
Project A
Project B
Both projects A and B
If the projects were mutually exclusive, which project(s) would be accepted according to the IRR method?
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Neither
Project A
Project B
Both projects A and B
Could there be a conflict with project acceptance between the NPV and IRR approaches when projects are mutually exclusive?
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Yes
No
The reason is
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the NPV and IRR approaches use the same reinvestment rate assumption so both approaches reach the same project acceptance when mutually projects are considered.
the NPV and IRR approaches use different reinvestment rate assumptions so there can be a conflict in project acceptance when mutually exclusive projects are considered.
Reinvestment at the
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IRR
WACC
Correct 5 of Item 3
is the superior assumption, so when mutually exclusive projects are evaluated the
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NPV
IRR
Correct 6 of Item 3
approach should be used for the capital budgeting decision.