Question

1. Kerria Inc. would like to buy $130,000 of new candy-making equipment. However, the company has a major loan maturing in three years and needs this money back at that time to avoid bankruptcy. The candy-making equipment is expected to increase the cash flows by $35,000 in the first year, $40,000 in the second year, and $50,000 a year for the following two years. Should Kerria Inc. buys the equipment at this time? Why or why not?

   		yes; because the money will be recovered in two years
   		yes; because the money will be recovered in less than three years
   		yes; because the money will be recovered in one year
   		no; because the money will be recovered in more than three years

2. You are considering an investment for which you require a 10 percent rate of return. The investment will cost $55,000 and produce cash inflows of $10,000 a year for 9 years. Should you accept this project based on its internal rate of return? Why or why not?

   		no; because the IRR is 9.17 percent
   		yes; because the IRR is 9.17 percent
   		yes; because the IRR is 11.17 percent
   		no; because the IRR is 11.17 percent

Answer 1

Answer 1.

Cost of equipment is $130000

Cash flow increase from investment in capital is $35000 in first year, $40000 in second year and $50000 in third year.

Upto third year only $125000 is recovered. It means money will be recovered in more than 3 years.

So answer is no.

no; because the money will be recovered in more than three years

Answer 2.

IRR is the rate where present value of cash inflows is equal to present value of cash outflows or investment amount

investment amount = 55000

Present value of cash inflows = Annual cash inflows *(1 - (1/(1+i)^n)/i

55000 = 10000*(1-(1/(1+i)^9))/i

assume i = 10%

PV=10000*(1-(1/(1+10%)^9))/10%

=57590.23816

assume i = 12%

PV =10000*(1-(1/(1+12%)^9))/12%

=53282.49792

We will find out irr by interpolation formula

interpolation formula = lower rate +((uper rate - lower rate)*(Uper value - actual investsment)/(uper price - lower price))

10% + ((12%-10%)*(57590.23816-55000)/(57590.23816-53282.49792))

=0.112 or 11.20%

This is near to 11.17%. So IRR is 11.17% more than required return, project is acceptable.

Answer is yes; because the IRR is 11.17 percent