Name: ___________________________________
NetID: _______________________
Prof. Q. Ma, HADM 2222 Fall 2009
1/6
HADM 2222 Fall 2009, Prof. Q. Ma
Homework assignment
#4
[Due 11:59 a.m. Friday, October 16, 2009, Statler 435 drop box]
1.
What is the IRR of the following set of cash flows?
Year Cash
Flow
0
-18,000
1
9,800
2
7,500
3
7,300
Solution:
The IRR is the interest rate that makes the NPV of the project equal to zero. So, the equation that defines the
IRR for this project is:
0 = –$18,000 + $9,800/(1+IRR) + $7,500/(1+IRR)
2
+ $7,300/(1+IRR)
3
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
IRR
= 18.49%
2.
Bumble’s Bees, Inc., has identified the following two mutually exclusive projects:
Year
Cash Flow A
Cash Flow B
0
-37,000
-37,000
1
19,000
6,000
2
14,500
12,500
3
12,000
19,000
4
9,000
23,000
a. What is the IRR for each of these projects? Using the IRR decision rule, which project should the
company accept? Is this decision necessarily correct?
Solution:
The IRR is the interest rate that makes the NPV of the project equal to zero. The equation for the IRR of
Project A is:
0 = –$37,000 + $19,000/(1+IRR) + $14,500/(1+IRR)
2
+ $12,000/(1+IRR)
3
+ $9,000/(1+IRR)
4
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
IRR
= 20.30%
The equation for the IRR of Project B is:
0 = –$37,000 + $6,000/(1+IRR) + $12,500/(1+IRR)
2
+ $19,000/(1+IRR)
3
+ $23,000/(1+IRR)
4
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
IRR
= 18.55%
Examining the IRRs of the projects, we see that the IRRA is greater than the IRRB, so IRR decision rule
implies accepting project A. This may not be a correct decision; however, because the IRR criterion has a
ranking problem for mutually exclusive projects. To see if the IRR decision rule is correct or not, we need to
evaluate the project NPVs.