Question

Suppose you have developed the following information for a potential investment: current market value is $1,200,000; anticipated loan to value ratio is .80 with 2 points; and predicated cash flows of ATCF1 = $38,560, ATCF2 = $41,780, ATCF3 = $37,210, ATCF4 = $39,127, and ATER4 = $191,730. Further, assume the investor's minimum required after-tax rate of return on equity is 12%.

a. What is the internal rate of return on this potential investment?

b. What is the profitability index on this investment?

Answer 1

Greetings,

A) Internal Rate of Return on an Investment is the rate that investor earns over a period of time (4 years in this question) on the investment made by him. In this case, 1200000 is the total investment size out of which 80% ie 960000 will be the debt investment and balance 240000 will be equity investment to be provided by investor.

So now you can feed the above figures in the excel worksheet and get the answer as under :-

240000 = (38560/1+r)+(41780/(1+r)^2)+(37210/(1+r)^3)+({39127+191730}/(1+r)^4)

Solve for r and it will throw up the answer =12.14% approx.

Note- Debt Investment of 960000 will be repaid at the end, if it is a bullet repayment and last CF of 191730 is after deducting that payment only.

B) Profitability Index shows Inflows per dollar of outflow. Suppose if PI is 1.5, it means investor is earning $1.5 for every dollar invested.

PI = present value of cash inflows/ present value of cash outfloes

In the given case, PV if outflows is 240000 and PV of inflows can be found out as under -

(38560/1.12)+(41780/1.12^2)+(37210/1.12^3)+(39127+191730)/(1.12^4)

PV of inflows = 240934

So PI = 240934/240000= 1.004 approx