Question

The Ziggy Trim and Cut Company can purchase equipment on sale for $4,300. The asset has a three-year life, will produce a cash flow of $1,200 in the first and second year, and $3,000 in the third year. The interest rate is 12%. Calculate the project's payback assuming end of year cash flows. Also, calculate project's IRR. Should the project be taken? Check your answer by computing the project's NPV.

Answer 1

Cash Flows:
Year 0 = -$4,300
Year 1 = $1,200
Year 2 = $1,200
Year 3 = $3,000

Payback Period:

Company can recoup initial investment of $2,400 in first 2 years and remaining $1,900 in third year

Payback Period = 2 + $1,900 / $3,000
Payback Period = 2.63 years

Internal Rate of Return:

Let IRR be i%

NPV = -$4,300 + $1,200/(1+i) + $1,200/(1+i)^2 + $3,000/(1+i)^3
0 = -$4,300 + $1,200/(1+i) + $1,200/(1+i)^2 + $3,000/(1+i)^3

Using financial calculator, i = 10.41%

IRR of the Project is 10.41%

You should not accept the project as IRR is less than interest rate.

Net Present Value:

NPV = -$4,300 + $1,200/1.12 + $1,200/1.12^2 + $3,000/1.12^3
NPV = -$136.60