Question

A firm evaluates all of its projects by applying the IRR rule. A project under consideration has the following cash flows:Year Cash Flow0 -$ 27,200 1 11,200 2 14,200 3 10,200 If the required return is 16 percent, what is the IRR for this project?Should the firm accept the project?NoYes

Answer 1

Answer:

IRR= 14,96%

The firm should not accept the project, due o the fact that the internal rate of return is lower than the required return. (14,96%<16%)

Explanation:

The internal rate of return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments. The internal rate of return (IRR) rule is a guideline for evaluating whether to proceed with a project or investment. The IRR rule states that if the internal rate of return on a project or investment is greater than the minimum required rate of return, then the project or investment should be pursued. If it is lower than the cost of capital or required rate o return, the best course of action is to reject the project.

$0 = (initial investment x -1) + CF1 / (1 + IRR) ^ 1 + CF2 / (1 + IRR) ^ 2 + ... + CFX / (1 + IRR) ^ X

Initial Invesment= Total initial investment costs year x-1

CFx= Cash Flow during period X

IRR= Internal rate of return

Because of the nature of the formula, however, IRR cannot be calculated analytically and must instead be calculated either through trial-and-error or using software programmed to calculate IRR.

In this case:

IRR= -27200+ 11200/(1+IRR)^1 + 14200/(1+IRR)^2 + 10200/(1+IRR)^3

IRR= 14,96%

The firm should not accept the project, due o the fact that the internal rate of return is lower than the required return. (14,96%<16%)