Question

Consider an investment that costs $100,000 and has a cash inflow of $25,000 every year for 5 years. The required return is 9% and required payback is 4 years.

• What is the payback period?

• What is the NPV?

• What is the IRR?

• Should we accept the project?

What decision rule should be the primary decision method?

When is the IRR rule unreliable?

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Answer 1

1.Payback period

Year	Cash inflows	Cumulative cash flows
0	-100,000	-100,000
1	25,000	-75,000
2	25,000	-50,000
3	25,000	-25,000
4	25,000	0
5	25,000	25,000

As per the above table, Payback period is 4 years as Cumulative cash inflow is zero in the 4th year.

2.NPV

Year	Cash flows	Discounted cash flows
0	-100,000	-100,000
1	25,000	22,935.7798
2	25,000	21,041.9998
3	25,000	19,304.587
4	25,000	17,710.6303
5	25,000	16,248.2847
	NPV	$ -2,758.72

The project is not profitable as NPV is $ -2,758.72(negative)

3.IRR

Year	Cash flows
0	-100,000
1	25,000
2	25,000
3	25,000
4	25,000
5	25,000
IRR	7.93%

Here, the project should be rejected as the IRR of the project is 7.93% which is below the required return of 9%

4. We should not accept the project as the project is having a negative NPV an IRR is less than the required return.

5. The Net present value (NPV) should be the primary decision method.

6.IRR rule is not reliable when we have abnormal cash flows. i.e positive and negative cashflows in following years