Capital Budgeting Case the Contemporaneous Research Proposal

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Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first."

The equation to calculating the internal rate of return is a complex one, based primarily on the value of the initial investment:

(Yousaf)

In the case of the first investment project, the equation to calculating the IRR would be as follows:

130 = 25 / (1 + r) 1 + 35 / (1 + r) 2 + 45 / (1 + r) 3 + 50 / (1 + r) 4 + 55 / (1 + r) 5

For project B, the equation is:

85 = 40 / (1 + r) 1 + 35 / (1 + r) 2 + 30 / (1 + r) 3 + 10 / (1 + r) 4 + 5 / (1 + r) 5

Given the complexity of these formulas, the method used is that of estimating results and verifying until a correct solution is identified. "We use linear interpolation to estimate the actual rates of return for the four investment alternatives. Linear interpolation is a trial and error method of estimating actual rates of return when such rates are different from tables or calculators" (Yousaf).

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For project A, an estimated internal rate of return of 9% would lead to the following:

130 = 25 / 1.09 + 35 / 1.18 + 45 / 1.29 + 50 / 1.41 + 55 / 1.53 130 = 158.89, which is false, meaning then that the IRR for project A is larger than 9%. Considering an IRR of 11%:

130 = 25 / 1.11 + 35 / 1.23 + 45 / 1.36 + 50 / 1.51 + 55 / 1.68 130 = 149.91, which is also false, requiring the need for an even larger estimation. For an IRR of 15%:

130 = 25 / 1.15 + 35 / 1.32 + 45 / 1.52 + 50 / 1.75 + 55 / 2.01 130 = 133.79; this result is the closest one, meaning then that the estimated IRR for project investment A is of 15.5%

For project B, the estimative calculations commence at a value of the internal return rate of 10%:

85 = 40 / 1.1 + 35 / 1.21 + 30 / 1.33 + 10 / 1.46 + 5 / 1.6 85 = 97.82, which is clearly false, meaning as such that the IRR is larger. For an estimated IRR of 15%:

85 = 40 / 1.15 + 35 / 1.32 + 30 / 1.52 + 10 / 1.75 + 5 / 2.01 85 = 89.23

Based on the previous calculations, the probable.....

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