3 Understanding the IRR and NPV Aa Aa The net present value

3. Understanding the IRR and NPV Aa Aa 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 Blue Hamster Manufacturing Inc.: Last Tuesday, Blue Hamster Manufacturing Inc. lost a portion of its planning and financial data when both its main and its backup servers crashed. The company\'s CFO remembers that the internal rate of return (IRR) of Project Gamma is 13.8%, but he can\'t recall how much Blue Hamster originally invested in the project nor the project\'s net present value (NPV). However, he found a note that detailed the annual net cash flows expected to be generated by Project Gamma. They are: YearCash Flow Year $1,600,000 Year 2 $3,000,000 Year 3 $3,000,000 Year 4 $3,000,000 The CFO has asked you to compute Project Gamma\'s initial investment using the information currently available to you. He has offered the following suggestions and observations: A project\'s 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 outflows-when the cash flows are discounted using the project\'s IRR . The level of risk exhibited by Project Gamma is the same as that exhibited by the company\'s average project, which means that Project Gamma\'s net cash flows can be discounted using Blue Hamster\'s 1090 WACC. Given the data and hints, Project Gamma\'s initial investment is (rounded to the nearest whole dollar) , and its NPV is A project\'s IRR will if the project\'s cash inflows decrease, and everything else is unaffected

Solution

Given IRR of 13.8%, NPV = 0

Hence

Initial investment = PV of future cash flows

= CF1/(1+IRR)^1 ……+CF4/(1+IRR)^4

= 1600,000/ 1.138+ 3000,000/1.138^2 + 3000,000/1.138^3+ 3000,000/1.138^4

=7546869

NPV using 10% rate

= CF1/(1+0.1)^1+ ……CF4/(1+0.1)^4 - Initial investment

= 1600,000/ 1.1+ 3000,000/1.1^2 + 3000,000/1.1^3+ 3000,000/1.1^4- 7546869

=690,000

IRR will decrease if the cash flows decrease

(This is because the returns will decrease with decline in cash flows)