Question

(Ignore income taxes in this problem.) Overland Corporation has gathered the following data on a proposed investment project:

Click here to view Exhibit 8B-1 and Exhibit 8B-2 to determine the appropriate discount factor(s) using tables.

Investment required in equipment	$	560,000
Annual cash inflows	$	82,000
Salvage value of equipment	$	0
Life of the investment		16	years
Discount rate		9	%

The company uses straight-line depreciation on all equipment. Assume cash flows occur uniformly throughout a year except for the initial investment.

The internal rate of return on the investment is closest to:    

8%

10%

12%

14%

Answer 1

Answer)              

Calculation of Internal rate of return on investment

Internal rate of return is the rate at which the present value of cash inflows will be equal to the present value of cash outflows.

In the given question, since cash outflow is occurring on purchase of equipment today, the present value of cash outflow will be equal to the initial investment.

Present value of cash inflows will be equal to the annual cash inflow discounting with Internal rate of return over the life of the equipment.

Present value of cash outflow = Annual cash inflow X Present value of annuity of $ 1 at Internal rate of return for 16 years

$ 560,000 = $ 82,000 X Present value of annuity of $ 1 at Internal rate of return for 16 years

Present value of annuity of $ 1 at internal rate of return for 16 years = $ 560,000/ $ 82,000

Present value of annuity of $ 1 at internal rate of return for 16 years = 6.892

On a perusal of present value of annuity of $ 1 against 16 years row at 12% is 6.974 and at 13% is 6.6039.

Since the above present value of annuity of $ 1 factor (i.e. 6.892) is nearest to $ 6.974, the Internal rate of return on investment is closest to 12%.