Question

An investor is trying to decide whether should would invest the Rs. 300,000 she received from the sale of her vanity in a blue whale venture or in a small fast food restaurant. If she invests in the blue whale venture she will receive Rs. 35,000 each quarter (starting three months from now). She expects to sell her share in the blue whale venture for Rs. 400,000 six years from now. If she invests in the fast food restaurant, she will have to put up another Rs. 100,000 one year from now. However starting 2 years from now, her profit will be Rs. 90,000 per year (paid in 4 equal parts every quarter) for 5 years, after which she will receive Rs. 350,000 from the sale of the business. Suppose investor can borrow/deposit any amount for interest of 12% compounded monthly. Which investment should she choose?

Answer 1

Before we proceed, one important point to note is - Investor would get lump sum and Quarterly payment at the end of period in both option.

Now approach which we should follow is to calculate IRR for both the options and higher than 12% (cost of borrowing) would be considered a better option.

In Below screenshot, i have considered each quarter as a period. so we will have 24 period for first option and 28 period for 2nd option.

Peiord 0 will have the cash outflow and period 4 as well will have cash outsflow for option 2 (given in question).

I used IRR function of excel to make the calculation easily. However if you wnat you can aslo use below formula but this formula is based on trial error method so excel is better option for calculating IRR.

Now, in below screen shot, i have used the approach explained above. With that, we will get IRR for both options of investment.However, they would be in Quartely frequency. So i have used below formula to convert them into yearly frequency.

Effective annual IRR = (1+Quarterly IRR)^ no of period in 1 year

With below screenshot, it is confirmed that both option have better IRR than the cost of borrowing. So investmet can be made in both by borrowing the adequate amount.

Also, if investor can invest only in 1 of the option then, Blue whale venture is better since IRR is higher.