Question

Problems 1-2 are based on the information given in the following table:

Year	A	B
0	-2,500	-6,000
1	746	1,664
2	746	1,664
3	746	1,664
4	746	1,664
5	746	1,664
IRR	15%	12%

The internal rate of return on the incremental cash flows is closest to _________.

	A.	4%
	B.	6%
	C.	8%
	D.	10%
	E.	12%

Answer 1

From the given information calculate the incremental cash flow between alternative B and alternative A.

ICF of B – A = CF of Alternative B – CF of Alternative A

Year	A	B	ICF of B - A
0	-2,500	-6,000	-3,500
1	746	1,664	918
2	746	1,664	918
3	746	1,664	918
4	746	1,664	918
5	746	1,664	918

The internal rate of return on the incremental cash flows of B – A is calculated using trial and error method.

Let the rate of interest is 9%. Calculate PW of the ICF using 9%.

PW = -3,500 + 918 (P/A, 9%, 5)

PW = -3,500 + 918 (3.88965) = 70.70

The PW is positive. So, increase the rate of interest to get negative PW.

Increase the rate of interest to 10% and calculate PW at 10%.

PW = -3,500 + 918 (P/A, 10%, 5)

PW = -3,500 + 918 (3.79079) = -20

Using linear interpolation

Incremental IRR = 9% + [70.70 – 0 ÷ 70.70 – (-20)] * 1%

Incremental IRR = 9.78%

The internal rate of return on the incremental cash flows is closest to D. 10%.