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 following case:

Free Spirit Industries is evaluating a proposed capital budgeting project (project Delta) that will require an initial investment of $1,600,000.

Free Spirit Industries 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. Free Spirit Industries WACC is 7%, and project Delta has the same risk as the firm's average project.

I!

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

Year Cash Flow

Year 1 $375,000

Year 2 $500,000

Year 3 $450,000

Year 4 $475,000

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

4.74%

4.50%

4.98%

5.21%

If this is an independent project, the IRR method states that the firm should accept or reject project Delta.

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.