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2. Internal rate of return (IRR)

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 this case:

Falcon Freight is evaluating a proposed capital budgeting project (project Delta) that will require an initial investment of $1,500,000.

Falcon Freight has been basing capital budgeting decisions on a projects 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. Falcon Freights WACC is 8%, and project Delta has the same risk as the firms average project.

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

Year	Cash Flow
Year 1	$300,000
Year 2	$425,000
Year 3	$475,000
Year 4	$450,000

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

4.43%

3.14%

3.69%

2.95%

If this is an independent project, the IRR method states that the firm should .

If the projects cost of capital were to increase, how would that affect the IRR?

The IRR would increase.

The IRR would decrease.

The IRR would not change.