3. Understanding the IRR and NPV The net present value (NPV) and internal rate f 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 company's CFO remembers that the internal rate of return (IRR) of Project Gamma is 13.2%, but he can't recall how much Green Caterpillar 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: Year Cash Flow Year 1 $2,400,000 Year 2 $4,500,000 Year 3 $4,500,000 Year 4 $4,500,000 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 Green Caterpillar's 9% WACC. Given the data and hints, Project Gamma's initial investment is dollar). A project's IRR will and its NPV is if the project's cash inflows decrease, and everything else is unaffected. (rounded to the nearest whole
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
solve these 2 pratice problems
![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 company's CFO remembers that the internal rate of return (IRR) of Project Gamma is 13.2%, but he can't recall
how much Green Caterpillar 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:
Year
Year 1
Year 2
Year 3
Year 4
Cash Flow
$2,400,000
$4,500,000
$4,500,000
$4,500,000
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 Green Caterpillar's 9% WACC.
Given the data and hints, Project Gamma's initial investment is
dollar).
A project's IRR will
, and its NPV is
if the project's cash inflows decrease, and everything else is unaffected.
✓ (rounded to the nearest whole](/v2/_next/image?url=https%3A%2F%2Fcontent.bartleby.com%2Fqna-images%2Fquestion%2Faf434c73-38f1-4a89-b981-edd99d760c82%2Fa54d43c6-a3a3-4791-a571-dc93ab05a7b8%2F70ql5t4_processed.png&w=3840&q=75)
![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 project's IRR.
Consider the following situation:
Celestial Crane Cosmetics is analyzing a project that requires an initial investment of $3,225,000. The project's expected cash flows are:
Year
Year 1
Year 2
Year 3
Year 4
Celestial Crane Cosmetics's WACC is 8%, and the project has the same risk as the firm's average project. Calculate this project's modified internal rate
of return (MIRR):
O -18.61%
O 16.69%
Cash Flow
$350,000
-175,000
500,000
500,000
O 22.25%
O 19.47%
If Celestial Crane Cosmetics's managers select projects based on the MIRR criterion, they should
Which of the following statements about the relationship between the IRR and the MIRR is correct?
O A typical firm's IRR will be greater than its MIRR.
O A typical firm's IRR will be less than its MIRR.
O A typical firm's IRR will be equal to its MIRR.
this independent project.](/v2/_next/image?url=https%3A%2F%2Fcontent.bartleby.com%2Fqna-images%2Fquestion%2Faf434c73-38f1-4a89-b981-edd99d760c82%2Fa54d43c6-a3a3-4791-a571-dc93ab05a7b8%2F4fipx1g_processed.png&w=3840&q=75)
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