Question

A project requires an initial investment of $1.2 million. It expects to generate a perpetual cash flow. The first year cash flow is expected at $100,000. The cash flows are then expected to grow at 1.25% forever. The appropriate cost of capital for this project is 11%. What is the project's IRR and should it be accepted based on the IRR rule?

Group of answer choices

IRR is 9.6%; project should not be accepted

IRR is 9.6%; project should be accepted

IRR is 11.6%; project should not be accepted

IRR is 11.6%; project should be accepted

IRR is 10.6%; project should be accepted

IRR is 10.6%; project should not be accepted

Answer 1

At irr,present value of inflows=present value of outflows.

Present value of growing perpetuity=Cash flow for next year/(Interest rate-Growth rate)

1,200,000=100,000/(interest rate-0.0125)

1,200,000(interest rate-0.0125)=100,000

1,200,000*interest rate-15000=100,000

interest rate=(100,000+15000)/1,200,000

=9.6%(Approx)

Hence since irr is less than cost of capital;project must be rejected.

Hence the correct option is :

IRR is 9.6%; project should not be accepted