Internal Rate of Return

5 minutes 5 Questions

The Internal Rate of Return (IRR) is an important concept used in Cost Benefit Analysis that calculates the overall return provided by the project. IRR is essentially the discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero and hence equalizes the present value of its costs with the present value of its benefits. The IRR allows project managers to compare and rank projects based on their profitability. A high IRR indicates that the project's returns are higher than its costs.

Guide to Understanding and Answering Questions on Internal Rate of Return

The Internal Rate of Return (IRR) is a crucial financial concept useful in investment decisions and project evaluation. It's a discount rate that makes the present value of expected future cash flows equal to the initial investment cost, hence achieving a net present value (NPV) of zero.

This essentially means that IRR is the percentage at which an investment breaks even in terms of NPV. When deciding on investments, a higher IRR implies a more desirable choice.

To calculate IRR, one requires a series of cash flows stemming from an investment and a calculation process known as iteration.

During an exam, if asked to calculate IRR:

Make sure to carefully understand the expected future cash flows given in the problem.
Use the correct formula or financial calculator to determine the IRR.
Do not forget to discuss the implication of the IRR value as an interpretation of the results is often expected.

Exam tip: If you are given an investment scenario with two or more investments, the one with the higher IRR will generally be the better investment. It's crucial not only to calculate the IRR correctly but also to interpret what it means in terms of potential gain or loss from the proposed investment.
Remember IRR is beneficial, but like all financial measures, it has its limitations and should not be used in isolation.

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Question 1

Two potential projects A and B have IRRs of 5% and 7%, respectively. If the hurdle rate is 6%, which project is financially more profitable based solely on the IRR?

Both are the same Project B Project A Cannot be determined

Correct Answer: Project B

Based on the question, the higher the Internal Rate of Return (IRR), the more profitable a project is. This rule applies as long as the IRR is higher than the hurdle rate. In our case, Project B has a higher IRR at 7%, which is more than the hurdle rate of 6%. On the other hand, Project A has an IRR of 5% which is less than the hurdle rate of 6%. Therefore, Project A is not financially viable. The statement 'Both are the same' is incorrect because the IRRs of the two projects are different. The statement 'Cannot be determined' is also incorrect because, based on the provided data, we can clearly determine that Project B is more profitable.

Question 2

You are reviewing two initiatives, Project Sunshine with an IRR of 14% and Project Moonlight, whose IRR isn't calculated yet. If the minimum attractive rate of return is 16%, should you consider Project Sunshine as a viable option?

Depends on project Moonlight Yes Not enough information No

Correct Answer: No

The Internal Rate of Return (IRR) for a project is a metric used in capital budgeting to estimate the profitability of potential investments. In this case, Project Sunshine has an IRR of 14%, which is less than the minimum attractive rate of return of 16%. Therefore, Project Sunshine should not be considered a viable option. The IRR needs to be greater than the minimum attractive rate of return for a project to be considered. The answer 'Yes' is incorrect because the IRR of Project Sunshine is less than the minimum attractive rate of return. 'Depends on project Moonlight' is irrelevant because the viability of each project should be evaluated separately. And 'Not enough information' is incorrect because we are given enough information to make a decision about Project Sunshine.

Question 3

Your company is contemplating to invest in a pipeline project estimated to cost $1M with an anticipated annual return of $150,000 for 10 years. Should the project be undertaken if the IRR is 12% and the cost of capital is 10%?

Data is insufficient No Yes Need more time to decide

Correct Answer: Yes

The project should be undertaken. The Internal Rate of Return (IRR) is the interest rate at which the net present value of all cash flows (both positive and negative) from a project or investment equal zero. If the IRR is higher than the cost of capital, it means the project or investment is expected to generate more return than the cost to finance it. In this case, the IRR is 12% which is greater than the cost of capital 10%. This indicates that the project is likely to generate returns more than its cost leading to increased value for the company. 'No' is not correct since the IRR is more than the cost of capital. 'Data is Insufficient' and 'Need more time to decide' are not correct, because the question provides enough information for a decision, especially for someone familiar with the concept of IRR and cost of capital such as a Certified Associate in Project Management.

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