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return is defined as the discount rate that equates the present value of the project’s futurecash flows with the project’s initial cash outlay. tFCF= the annual free cash flow in time period t (this can take on either positive ornegative value)IO = the initial cash outlayn = the project’s expected lifeIRR = the project’s internal rate of return14IOIRRFCFIRRnttt11:
The decision criterion is accepted the project if the internal rate of return isgreater than or equal to the required rate of return, because the firm is earning that itsshareholders require. On the other hand, reject the project if the internal rate of return isless than the required rate of return, because this will decrease the firm’s stock price.This accept-reject criterion can be stated as:IRR ≥ required rate of return : AcceptIRR < required rate of return : RejectThere are some advantages and disadvantages by using IRR method. Firstadvantage is IRR is the perfect use of time value of money theory. Besides that, it is alsoa good method of capital budgeting in which all the cash flows are equally important.Moreover, if IRR is higher than its cut off rate (cost of capital), then it will givemaximum profitability to shareholders. On the other hand, the disadvantage by usingIRR method is IRR requires a complicated calculation that can only be solved throughtrial and error or a computer spreadsheet. Also, if just want to choose one of twoprojects, IRR may not be the best method to determine which one to choose due to IRRis not helpful for comparing two mutually exclusive investments. In this case of Worldwide Paper Company, we have computed the internal rate ofreturn (IRR) that shown in table below.Required rate of return9.67%YearCash FlowPVIFPresent Value of Cash Flow0(16.00)1.0000(16.00)10.480.90190.4323.900.81343.1734.500.73363.3015
44.500.66162.9854.500.59672.6964.500.53822.4272.080.48541.01NPV0.00IRR10.88%Table 5To get the present value of free cash flows each year, we just multiply the cashflow and the present value interest factor (PVIF). For computing the IRR, we are usingthe goal seek function in Microsoft Excel. It is more simple and accurate compare withusing trial and error method. Goal seek ask us to change the value of one cell to makethe value of another cell (called the target cell) equal to specific value. We use the goalseek to change the required rate of return to set the NPV equal to zero. At last, we aregetting the result which shows that the IRR is 10.88%. The updated WACC is 9.67%, itshows that the project is fulfill the acceptation criteria in IRR method, because the IRRof the project is greater than the required rate of return (WACC) of the project. Thus, ourconclusion is to accept this project because compared with the required rate of return,the IRR is larger. This mean that Worldwide Paper Company is earning more the ratethat its shareholders require, hence, it will give maximum profitability to shareholders.