2. Internal rate of return (IRR) Aa 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 this case: Consider the following case Falcon Freight is evaluating a proposed capital budgeting project (project Delta) that will require an initial investment of $1,500,000. Falcon Freight 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 percentages and returns are easier to understand and to compare to required returns. Falcon Freight's WACC is 8% and project Delta 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 Delta's IRR? Year Cash Flo Year $325,000 Year 2 $450,000 Year 3 $400,000 Year 4 $475,000 o 4.11% 0 3.74% 4.49% 3.18% 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 not change The IRR would increase The IRR would decrease. 3. Understanding the IRR and NPV Aa Aa The net present value (NPV) and internal rate of return (IRR) methods of investment analysis are interrelated and are sometimes used together to make capital budgeting decisions Consider the case of Cold Goose Metal Works Inc. Last Tuesday, Cold Goose Metal Works Inc. lost a portion of its planning and financial data when both its main and its backup servers crashed. The company's CFO remembers that the internal rate of return (IRR) of Project Lambda is 13.2%, but he can't recall how much Cold Goose originally invested in the project nor the project's net present value (NPV). However, he found a note that detailed the annual net cash flows expected to be generated by Project Lambda. They are Year Cash Flow Year 1 $1,600,000 Year 2 $3,000,000 Year 3 $3,000,000 Year 4 $3,000,000 The CFO has asked you to compute Project Lambda's initial investment using the information currently available to you. He has offered the following suggestions and observations: A project's IRR represents the return the project would generate when its NPV is zero or the discounted value of its cash inflows equals the discounted value of its cash outflows-when the cash flows are discounted using the project's IRR. The level of risk exhibited by Project Lambda is the same as that exhibited by the company's average project, which means that Project Lambda's net cash flows can be discounted using Cold Goose's 7% W ACC. Given the data and hints, Project Lambda's initial investment is (rounded to the nearest whole dollar) and its NPV is A project's IRR will if the project's cash inflows decrease, and everything else is unaffected