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dgeting criteria - 41Lecture Problems 5ÜI Scream Ice Cream is evaluating a project that has an NPV of $3,000; would cost $72,000 today; is expected to produce annual cash flows that grow by 2.35 percent per year forever; and is expected to have the first annual cash flow be $4,932 in 1 year. What is the IRR of the project?What is the internal rate of return for a project that is expected to cost $8,700 today; produce a cash flow of $9,900 in 1 year; and have an NPV of $700? ÜWhat is the internal rate of return for a project that is expected to cost $8,700 today; produce a
dgeting criteria - 42Capital Budgeting Criteria: IRRÜKey strengths of IRR and IRR ruleèAppealing because it is a rateèRecognizes the time value of moneyèRecognizes project riskèDecision rule is not based on managerial discretion, but on economic principlesèFor projects with conventional cash flows, rule is appropriate and always leads to acceptance of projects that create value and always leads to rejection of projects that destroy value•Produces same results as NPV rule for these types of projects
dgeting criteria - 44Capital Budgeting Criteria: IRRÜThree important cases when IRR rule is not appropriate and should not be usedèPositive expected cash flow or flows and then negative expected cash flow or flowsèExpected cash flows that flip sign more than once•For example, expected cash flows are negative then positive then negativeèExpected cash flows that never flip sign•All expected cash flows are positive or all expected cash flows are negative
dgeting criteria - 45Capital Budgeting Criteria: IRR - ExampleÜQuestion: which of the following projects are appropriate to evaluate with the IRR rule and which are not appropriate for the IRR rule?ProjectC0C1C2C3C4A-10040404040B-100000300C-10000040D100000-1E-100808080-10F-10010101010G4040404040H40404040-100
dgeting criteria - 46Capital Budgeting Criteria: IRR - ExampleÜQuestion: which of the following projects are appropriate to evaluate with the IRR rule and which are not appropriate for the IRR rule?èAppropriate – projects with conventional cash flows•Magnitude of expected cash flows is irrelevantèNot appropriate – all other projectsProjectC0C1C2C3C4A-10040404040B-100000300C-10000040D100000-1E-100808080-10F-10010101010G4040404040H40404040-100