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A firm evaluates all of its projects by applying the IRR rule. If the required return is 18%,...

Question:

A firm evaluates all of its projects by applying the IRR rule. If the required return is 18%, should the firm accept the following project?

Year - Cash Flow
0 - $28,000
1 - $12,700
2 - $15,890
3 - $8,230

Internal Rate of Return:

Internal rate of return (IRR) is the rate at which the present value of all the cash inflows of a project is equal to the initial investment. In other words, IRR is the rate at which NPV = 0. It is one of the selection criteria of a project. The form accepts the project if IRR is greater than the required rate of return.

Answer and Explanation:

The firm should not accept the project.

  • Initial investment = $28,000
  • Cash flow in year 1 = $12,700
  • Cash flow in year 2 = $15,890
  • Cash flow in year 3 = $8,230

Let the IRR be r

{eq}$28,000 = \frac{12,700}{(1 + r)^1} + \frac{15,890}{(1 + r)^2} + \frac{8,230}{(1 + r)^3}\\ r = 16.07\% {/eq}

Required rate of return = 18%

As the IRR of the project is less than the required rate of return, the firm should not accept the project.


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