Question

A firm is considering investing in a 25 year capital budgeting project with a net investment of 14 Million. The project is expected to generate annual net cash flows each year of 2 million and a terminal value at the end of the project of 1 million. The firms costs of capital is 14 percent and marginal tax rate is 40%. What is the internal rate of return of this investment?

Answer 1

IRR = 7.1% Approx.

CALCULATION: -

Information given: -

Initial investment = $14,000,000

Net cashflows = $2,000,000

Terminal value= $1,000,000

after-tax net cashflows= before tax cashflows * (1-tax rate)

= $2,000,000 (1- .4)

= $1,200,000

Net terminal value = beore tax terminal value * (1- tax-rate)

= $1,000,000 * (1-.4)

=$600,000

Internal Rate Of return(IRR) is the interest rate (discount rate) that makes the NPV of the project zero. In other words the present value of its expected cash inflows will be equal to the present value of its expected cash outflows. IRR of this project can be calculated using trial and error method as follows:-

for the calculation First lets assume 6% as the IRR

a. NPV with 6%

NPV with equal cashflow in future periods = (cashflow per period * PVIFA 6%,25)+(terminal value * PVIF 6%,25) - Initial investment

= ($1,200,000 * 12.783) + ($600,000 * .232998 )- $14,000,000

= $1479398.8

the NPV of discound rate 6% is a positive figure lets assume another rate higher than 6% as IRR, the assumed value is 8%.

b. NPV with 8%

NPV with equal cashflow in future periods = (cashflow per period * PVIFA 8%,25)+(terminal value * PVIF 8%,25) - Initial investment

= ($1,200,000 * 10.675) + ($600,000 * 0.14601790 )- $14,000,000

= -$1102289.26

Since the NPV of 6% is positive and 8% is negative IRR lies between 6% and 8%, to get the exact IRR we have to interpolate using the following formula:-

IRR = 6% +[(8%-6%) * {$1479398.8 / ($1479398.8 + $1102289.26)}]

= 6% + .1.1%

IRR = 7.1% Approx.