Question

Acme Corp has a target debt/equity ratio of 0.35. It was $350 million in bonds outstanding with a yield of 7% and 50 million shares of stock outstanding with a current market price of $20 per share. The company’s beta is 1.32 and the risk-free rate of interest is 4% with a market risk premium of 6%. The firm has a tax rate of 25%. The company is looking to raise $250 million to build a second factory. The new factory will increase output substantially. The table below shows the anticipated cash flows generated from the new factory including a salvage value in year 5. What is the IRR of this project?

Year	Cash Flow ($mill)
0	-250
1	50
2	50
3	100
4	100
5	100

Group of answer choices

13.47%

14.21%

15.58%

12.26%

Answer 1

Answer is 15.58%

We can find IRR using trial and error method:

For that we need two discounting rates, where one rate should discount the cash flows to lesser than cash outflow and the other should discount the cash flows to more than cash outflow. By looking at the choices we can see that IRR should be between 12% and 16%. So let us take those rates.

you can see that when cash flows are discounted at 12% it gives more than the cash outflow and when it is discounted with 16% it gives less than 250.

From the group of choices we know that our answer is 15.58%, but there is small different between our answer, that is because of the difference in discounting rates we took. So let us take two discounting rates which are closer to IRR. Say 15% and 16%.

Then we will get:

Therefore,

Therefore, IRR = 15.58%