The internal rate of return (IRR) is the
Answer(s): C
The IRR is the interest rate at which the present value of the expected future cash inflows is equal to the present value of the cash outflows for a project. Thus1 the IRR is the interest rate that will produce a net present value (NPV) equal to zero. The IRR method assumes that the cash flows will be reinvested at the internal rate of return.
A project requires an initial cash investment at its inception of $10,000, and no other cash outflows are necessary. Cash inflows from the project over its 3-year life are $6,000 at the end of the first year, $5,000 at the end of the second year, and $2,000 at the end of the third year. The future value interest factors for an amount of $1 at the firm's desired rate of return of 8% areThe modified IRR (MIRR)for the project is closest to
Answer(s): D
The MIRR is the interest rate at which the present value of the cash outflows discounted at the firm's desired rate of return equals the present value of the terminal value. The terminal value is the future value of the cash inflows assuming they are reinvested at the firm's desired rate of return. The present value of the outflows is $10,000 because no future outflows occur. The terminal value is $14,396 [($6,000 x 1.166) + ($5,000 x 1.08) + ($2,000 x 1.00)]. Accordingly, the present value of $1 interest factor for the rate at which the present value of the outflows equals the present value of the terminal value is .695 ($10,000 ÷ $14,396). This factor is closest to that for 12%.
Suzie owns a computer reselling business and is expanding it. She is presented with two options. Under Proposal A, the estimated investment for the expansion project is $85,000, and it is expected to produce after--tax cash flows of $25,000 for each of the next 6 years. Proposal B involves an investment of $32,000 and after-tax cash flows of $10,000 for each of the next 6 years. Between which two desired rates of return will Suzie be indifferent to either proposal?
The desired rate of return at which the two projects will produce the same NPV can be found by calculating the IRR of the difference in cash flows between the two projects. Proposal A requires an additional investment of $53,000 and generates extra cash flows of $15,000 for 6 years. Dividing the incremental investment by the annual cash flows yields a result of 3.533 ($53,000 + $15000). In other words, this is the present value factor necessary to make the cash flows equal the incremental investment. Consulting the present value table for an ordinary annuity for 6 years reveals that 3.533 is somewhere between 16% and 18%.
The net present value method of capital budgeting assumes that cash flows are reinvested at
The NPV method assumes that periodic cash inflows earned over the life of an investment are reinvested at the company's cost of capital (i.e., the discount rate used in the analysis). This is contrary to the assumption under the internal rate of return method, which assumes that cash inflows are reinvested at the internal rate of return. As a result of this difference, the two methods will occasionally give different rankings of investment alternatives.
The net present value of a proposed investment is negative; therefore, the discount rate used must be
Answer(s): A
The higher the discount rate, the lower the NPV). The IRR is the discount rate at which the NPV is zero. Consequently, if the NPV is negative1 the discount rate used must exceed the IRR.
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