The Basics of Capital Budgeting: IRR IRR A project's internal rate of return (IRR) is the -select- Ttn o 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 on a bond. The equation for o calculating the IRR is: CFI NPV CFM CFO (1 +IRR) o 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-Tt The IRR calculation assumes that cash flows are reinvested at the Select- r the IRR is Select than the project's risk-adjusted cost of capital, then the project should be accepted; however, if the IRR is less than the project's risk-adjusted cost of capital, then the project should be C-select- Because of the IRR reinvestment rate t assumption, when select projects are evaluated the IRR approach can lead to conflicting results from the NPW method. Two basic conditions can lead to conflicts between NPV and IRR: C-select- differences (earlier c flows in project vs. later cash flows in the other project) project is larger When mutually and project size (the cost of one than the other). exclusive projects are considered, then the Select' 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 nows are shown on the time line below, Depreciation, salvage values, net operating working capital requirements, and tax effects are all included in these cash Both projects have 4-vear lives, and they have risk characteristics similar to the firm's average project. Bellinger's WACC is 9% Project A 1,300 640 310 280 Project B 1,300 240 245 850 430