# Return is defined as the discount rate that equates

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return is defined as the discount rate that equates the present value of the project’s future cash flows with the project’s initial cash outlay. t FCF = the annual free cash flow in time period t (this can take on either positive or negative value) IO = the initial cash outlay n = the project’s expected life IRR = the project’s internal rate of return 14 IO IRR FCF IRR n t t t 1 1 :
The decision criterion is accepted the project if the internal rate of return is greater than or equal to the required rate of return, because the firm is earning that its shareholders require. On the other hand, reject the project if the internal rate of return is less 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 : Accept IRR < required rate of return : Reject There are some advantages and disadvantages by using IRR method. First advantage is IRR is the perfect use of time value of money theory. Besides that, it is also a 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 give maximum profitability to shareholders. On the other hand, the disadvantage by using IRR method is IRR requires a complicated calculation that can only be solved through trial and error or a computer spreadsheet. Also, if just want to choose one of two projects, IRR may not be the best method to determine which one to choose due to IRR is not helpful for comparing two mutually exclusive investments. In this case of Worldwide Paper Company, we have computed the internal rate of return (IRR) that shown in table below. Required rate of return 9.67% Year Cash Flow PVIF Present Value of Cash Flow 0 (16.00) 1.0000 (16.00) 1 0.48 0.9019 0.43 2 3.90 0.8134 3.17 3 4.50 0.7336 3.30 15
4 4.50 0.6616 2.98 5 4.50 0.5967 2.69 6 4.50 0.5382 2.42 7 2.08 0.4854 1.01 NPV 0.00 IRR 10.88% Table 5 To get the present value of free cash flows each year, we just multiply the cash flow and the present value interest factor (PVIF). For computing the IRR, we are using the goal seek function in Microsoft Excel. It is more simple and accurate compare with using trial and error method. Goal seek ask us to change the value of one cell to make the value of another cell (called the target cell) equal to specific value. We use the goal seek to change the required rate of return to set the NPV equal to zero. At last, we are getting the result which shows that the IRR is 10.88%. The updated WACC is 9.67%, it shows that the project is fulfill the acceptation criteria in IRR method, because the IRR of the project is greater than the required rate of return (WACC) of the project. Thus, our conclusion 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 rate that its shareholders require, hence, it will give maximum profitability to shareholders.