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 - 42
Capital Budgeting Criteria: IRR
Ü
Key strengths of IRR and IRR rule
è
Appealing because it is a rate
è
Recognizes the time value of money
è
Recognizes project risk
è
Decision rule is not based on managerial discretion,
but on economic principles
è
For 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 - 44
Capital Budgeting Criteria: IRR
Ü
Three important cases when IRR rule is not
appropriate and should not be used
è
Positive expected cash flow or flows and then
negative expected cash flow or flows
è
Expected cash flows that flip sign more than once
•
For example, expected cash flows are negative then
positive then negative
è
Expected cash flows that never flip sign
•
All expected cash flows are positive or all expected cash
flows are negative

dgeting criteria - 45
Capital Budgeting Criteria:
IRR - Example
Ü
Question: which of the following projects are
appropriate
to evaluate with the IRR rule and
which are not appropriate for the IRR rule?
Project
C0
C1
C2
C3
C4
A
-100
40
40
40
40
B
-100
0
0
0
300
C
-100
0
0
0
40
D
100
0
0
0
-1
E
-100
80
80
80
-10
F
-100
10
10
10
10
G
40
40
40
40
40
H
40
40
40
40
-100

dgeting criteria - 46
Capital Budgeting Criteria:
IRR - Example
Ü
Question: which of the following projects are
appropriate
to evaluate with the IRR rule and
which are not appropriate for the IRR rule?
è
Appropriate – projects with conventional cash flows
•
Magnitude of expected cash flows is irrelevant
è
Not appropriate – all other projects
Project
C0
C1
C2
C3
C4
A
-100
40
40
40
40
B
-100
0
0
0
300
C
-100
0
0
0
40
D
100
0
0
0
-1
E
-100
80
80
80
-10
F
-100
10
10
10
10
G
40
40
40
40
40
H
40
40
40
40
-100

dgeting criteria - 47