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 Purple Whale Foodstuffs Inc.:

Purple Whale Foodstuffs Inc. is evaluating a proposed capital budgeting project (project Sigma) that will require an initial investment of $900,000.

Purple Whale Foodstuffs Inc. 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. Purple Whale Foodstuffs Inc.s WACC is 9%, 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	$300,000
Year 2	$425,000
Year 3	$475,000
Year 4	$450,000

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

28.63%

27.27%

24.54%

32.72%

If this is an independent project, the IRR method states that the firm should _____(accept/reject) project Sigma .

If the projects cost of capital were to increase, how would that affect the IRR?

The IRR would increase.

The IRR would decrease.

The IRR would not change.