Question

What should be the value of the interest rate such a way that a project that costs $1800 in year 0 and pays $288 annually for 10 years be equivalent to each other?

Answer 1

Project cost = 1,800

Annual pay back = 288 for 10 years

At what interest rate both will be equivalent to each other?
Using present worth method, at what interest rate PW of Cost will be equivalent to PW of outflows.

The interest rate is otherwise called as Internal Rate of Return (IRR). Calculating IRR using Trial and Error Method.

Let the rate of interest is 10%. Calculate PW of the cash flows at 10%.

PW = -1,800 + 288 (P/A, 10%, 10)

PW = -1,800 + 288 ( 6.14457) = -30.36

The PW is negative. Therefore, decreasing the rate of interest to get positive PW. Calculate the PW of the cash flows at 9%.

PW = -1,800 + 288 (P/A, 9%, 10)

PW = -1,800 + 288 (6.41766) = 48.28

Now use interpolation formula to calculate IRR

IRR = 9% + [48.28 - 0 / 48.28 - (-30.36)] * 1%

IRR = 9.6%

Answer - The rate of interest that makes the cash flows equal is 9.6%.