Pandora, Inc. is considering a five-year project that has an initial outlay or cost of $70,000. The cash inflows from its project for years 1, 2, 3, 4 and 5 are all the same at $14,000. The borrowing costs are 10%. What is the IRR?
Should Pandora use the IRR method to evaluate this project? Explain.
What will be an ideal response?
Answer: Using a financial calculator or software program like Excel or trial and error, we get an IRR that is exactly equal to zero percent (this is because the undiscounted sum of all future inflows equals the initial outlay, e.g., $14,000 × 5 = $70,000). It does not appear that Pandora will accept this project since its borrowing costs of 10% will be greater than 0%. Thus, Pandora can use the IRR method if it likes because it does indicate the project should not be accepted. Pandora can verify its rejection decision of the project by computing its NPV, which is about -$16,929.
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