IRR

A project's internal rate of return (IRR) is the-Select-

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-Select-

YTM

coupon

gain on a bond.

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-Select-

IRR

one

zero

.

The IRR calculation assumes that cash flows are reinvested at the-Select-

IRR

NPV

WACC

. If the IRR is-Select-

less

greater

than the project's cost of capital, then the project should be accepted; however, if the IRR is less than the project's cost of capital, then the project should be-Select-

accepted

rejected

. Because of the IRR reinvestment rate assumption, when-Select-

mutually exclusive

independent company

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:-Select-

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-Select-

IRR

NPV

either

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 8%.

Project A-1,050 610 385 290 330

Project B-1,050 210 320 440 780

What is Project A's IRR? Round your answer to two decimal places.

What is Project B's IRR? Round your answer to two decimal places.

If the projects were independent, which project(s) would be accepted according to the IRR method?

If the projects were mutually exclusive, which project(s) would be accepted according to the IRR method?

Could there be a conflict with project acceptance between the NPV and IRR approaches when projects are mutually exclusive?

The reason is?

Reinvestment at the-Select-

IRR

WACC

is the superior assumption, so when mutually exclusive projects are evaluated the-Select-

NPV

IRR

approach should be used for the capital budgeting decision.