2. Internal rate of return (IRR)

2. Internal rate of return (IRR) Aa Aa El 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 Grey Fox Aviation Company: Consider the following case: Grey Fox Aviation Company is evaluating a proposed capital budgeting project (project Sigma) that will require an initial investment of $750,000. Grey Fox Aviation 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. Grey Fox Aviation Company's WACC is 10%, 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 $350,000 $475,000 $400,000 $475,000 32.80% 36.90% 38.95% 41.00% If this is an independent project, the IRR method states that the firm should accept project Sigma reject project Sigma 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: The project with the greatest IRR, assuming that both projects have the same risk as the firm's average project The project with the greater future cash inflows, 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