Question

You are considering two mutually exclusive projects. Project A has cash flows of −$125,000, $51,400, $52,900, and $63,300 for Years 0 to 3, respectively. Project B has cash flows of −$85,000, $23,100, $28,200, and $69,800 for Years 0 to 3, respectively. Project A has a required return of 9 percent while Project B's required return is 11 percent. Should you accept or reject these mutually exclusive projects based on IRR analysis?

Answer 1

Answer:

Explanation:

The Internal Rate of Return (IRR) finds the profitability of the money that remains invested during the life of a project. It is also known as the discount rate that makes the Net Present Value (NPV) equal to cero. So, if we calculate the NPV with the IRR we will find that it is equal to cero and then the project does not create or destroy value.  

As its name indicates, the required rate of return is the minimum return an investor expects when he or she invest on a project.  

Then, if the money of both projects remains invested during the life of the project, both projects are good options for the investor. But because they are mutually exclusive, we must choose one. If the money of project B remains invested in the life of the project, then this will have a greater internal rate of return and you should choose this one. But it is better to consider other financial indicators, because the IRR assumes that all of the money would be invested and re-invested in the project, and in real life maybe investor do not re-invest what they earn on the same project and at the same rate.

The figure attached shows the IRR formula. But I calculated using Excel: first, I put the cash flows of each year (the first one is negative because it is an investment). Then I used the formula: "=IRR(D5:C8)" for project A and "=IRR(E5:E8)" for project B.