3. Understanding the IRR and NPV

The net present value (NPV) and internal rate of return (IRR) methods of investment analysis are interrelated and are sometimes used together to make capital budgeting decisions.

Consider the case of Green Caterpillar Garden Supplies Inc.:

Last Tuesday, Green Caterpillar Garden Supplies Inc. lost a portion of its planning and financial data when both its main and its backup servers crashed. The companys CFO remembers that the internal rate of return (IRR) of Project Zeta is 14.6%, but he cant recall how much Green Caterpillar originally invested in the project nor the projects net present value (NPV). However, he found a note that detailed the annual net cash flows expected to be generated by Project Zeta. They are:

Year	Cash Flow
Year 1	$2,000,000
Year 2	$3,750,000
Year 3	$3,750,000
Year 4	$3,750,000

The CFO has asked you to compute Project Zetas initial investment using the information currently available to you. He has offered the following suggestions and observations:

	A projects IRR represents the return the project would generate when its NPV is zero or the discounted value of its cash inflows equals the discounted value of its cash outflowswhen the cash flows are discounted using the projects IRR.
	The level of risk exhibited by Project Zeta is the same as that exhibited by the companys average project, which means that Project Zetas net cash flows can be discounted using Green Caterpillars 8% WACC.

a. Given the data and hints, Project Zetas initial investment is (choose one) 9,406,225 9,683,213 10,793,380 9,266,330

b. , and its NPV is [ 1,687,153 1,533,775 1,303,709 1,227,020 ] (choose one: rounded to the nearest whole dollar).

c. A projects IRR will

stay the same or decrease or increase if the projects cash inflows decrease, and everything else is unaffected.

The IRR evaluation method assumes that cash flows from the project are reinvested at the same rate equal to the IRR. However, in reality the reinvested cash flows may not necessarily generate a return equal to the IRR. Thus, the modified IRR approach makes a more reasonable assumption other than the projects IRR.

Consider the following situation:

Fuzzy Button Clothing Company is analyzing a project that requires an initial investment of $550,000. The projects expected cash flows are:

Year	Cash Flow
Year 1	$350,000
Year 2	150,000
Year 3	400,000
Year 4	425,000

d. Fuzzy Button Clothing Companys WACC is 10%, and the project has the same risk as the firms average project. Calculate this projects modified internal rate of return (MIRR): choose one

20.39%

16.69%

18.54%

17.61%

e. If Fuzzy Button Clothing Companys managers select projects based on the MIRR criterion, they should (reject or accept) this independent project.

f. Which of the following statements best describes the difference between the IRR method and the MIRR method?

- The IRR method uses only cash inflows to calculate the IRR. The MIRR method uses both cash inflows and cash outflows to calculate the MIRR.

- The IRR method assumes that cash flows are reinvested at a rate of return equal to the IRR. The MIRR method assumes that cash flows are reinvested at a rate of return equal to the cost of capital.

- The IRR method uses the present value of the initial investment to calculate the IRR. The MIRR method uses the terminal value of the initial investment to calculate the MIRR.