Question

Suppose your firm is considering investing in a project with the cash flows shown as follows, that the required rate of return on projects of this risk class is 8 percent, and that the maximum allowable payback and discounted payback statistic for the project are three and three and a half years, respectively.

Time	0	1	2	3	4	5
Cashflow	-100,000	30,000	45,000	55,000	30,000	10,000

Use the IRR decision rule to evaluate this project; should it be accepted or rejected and why?    

Answer 1

First of all we have to check if the payback period and Discounted payback period less than three and half years.

Payback period is simply the time taken by the project to recover the intitial cash outlay.

So, we take the cumulative cash flows or add the yearly cash flows till the time the time the initial cash outflow is fully recovered. At the end of second year, we have to recover 25,000 and the cash flow for the third year is 55,000 ,so our initial cash outflow would simply be recovererd by 3rd year. The fraction can be calculated by dividing 25,000 by 55,000 which is 0.45.

Therefore the investment can be recovered in 2.45 years.

Similar is the case with Discounted payback period, we just have to discount the future cash flows to the present and then repeat the same process we did in payback period.

To discount we just use the PV(Rate,periods,pmt,fv) formula in excel.

The payback and the discounted payback periods of the project are lower than what the firm can bear.

To calculate the IRR.

We just use the IRR Function. which is =IRR(values). According to the IRR rule, the IRR Should be greated than the project rate of return in order to accept the project.

So, 23% > 8%, Hence we accept this project.