Capital Budgeting and the Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) of the project is approximately 18%. This is proportion of the initial cost that the management aspires the project will be able to produce in terms of profits on an annual basis for the seven years. It is a relatively low figure, especially given that the cost of capital is estimated at 14%.

The forecast of 3% inflation rate should be of great concern to Peru. This is due to the fact that inflation is a factor related to myriad macro and micro economic aspects. Political instability, for instance, could highly affect the rate. In addition, the rate could also be affected by such factors as interest rates, foreign exchange, among other macroeconomic factors (Baker & English 2011).

On the other hand, the scenario that a new legislation could lead to an increase in the cost of the project should also of concern to Peru. It is estimated that the enactment of a pending environmental law could increase the project’s operational cost by $1.5 million. Peru intends to finance the project through a $9 million loan at a cost 8% annually, and the increase in the cost may lead to financial distress.

Cost of capital and IRR are two measures used to estimate a project’s future cash flow (Baker & English 2011). The chief difference between the two is that cost of capital is used by external investors (equity holders) to access the potential future earnings, while IRR is employed by internal management to estimate future cash flows. Following this definition, one would expect IRR to be high than cost of capital because rational managers always aspire to achieve more than investors’ expectations. This is true in the case of “Transcendental zirconium ore” (IRR is 18% while the cost of capital is 14%).

Reference

Baker, H. & English, P 2011, Capital budgeting valuation financial analysis for today’s investment projects, Hoboken, N.J., Wiley.

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