2. Internal rate of return (IRR)

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 Falcon Freight:

Falcon Freight is evaluating a proposed capital budgeting project (project Sigma) that will require an initial investment of $800,000.

Falcon Freight has been basing capital budgeting decisions on a projects 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. Falcon Freights WACC is 7%, and project Sigma has the same risk as the firms average project.

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

Year	Cash Flow
Year 1	$375,000
Year 2	$500,000
Year 3	$425,000
Year 4	$500,000

Which of the following is the correct calculation of project Sigmas IRR?

a. 48.77%

b. 40.64%

c 32.51%

d. 44.70%

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:

A. The project that requires the lowest initial investment, assuming that both projects have the same risk as the firms average project

B. The project with the greater future cash inflows, assuming that both projects have the same risk as the firms average project

C. The project with the greatest IRR, assuming that both projects have the same risk as the firms average project

If this is an independent project, the IRR method states that the firm should ACCEPT OR REJECT