3. Understanding the IRR and NPV
The net present value (NPV) and internal rate of return (IRR)methods of investment analysis are interrelated and are sometimesused together to make capital budgeting decisions.
Consider the case of Cold Goose Metal Works Inc.:
Last Tuesday, Cold Goose Metal Works Inc. lost a portion of itsplanning and financial data when both its main and its backupservers crashed. The company’s CFO remembers that the internal rateof return (IRR) of Project Omicron is 13.2%, but he can’t recallhow much Cold Goose originally invested in the project nor theproject’s net present value (NPV). However, he found a note thatdetailed the annual net cash flows expected to be generated byProject Omicron. They are:
Year | Cash Flow |
|---|
| Year 1 | $1,800,000 |
| Year 2 | $3,375,000 |
| Year 3 | $3,375,000 |
| Year 4 | $3,375,000 |
The CFO has asked you to compute Project Omicron’s initialinvestment using the information currently available to you. He hasoffered the following suggestions and observations:
| • | A project’s IRR represents the return the project wouldgenerate when its NPV is zero or the discounted value of its cashinflows equals the discounted value of its cash outflows—when thecash flows are discounted using the project’s IRR. |
| • | The level of risk exhibited by Project Omicron is the same asthat exhibited by the company’s average project, which means thatProject Omicron’s net cash flows can be discounted using ColdGoose’s 9% WACC. |
Given the data and hints, Project Omicron’s initial investmentis ________ , and its NPV is ________ (rounded to the nearest wholedollar).
A project’s IRR will ________ if the project’s cash inflowsincrease, and everything else is unaffected.
