Question

Dow Chemical Inc.is considering investing in a project that will cost $152,000 and have no salvage value at the end of its 5-year life. It is estimated that the project will generate annual cash inflows of $40,000 each year. The company has a hurdle or cutoff rate of return of 9%.

Instructions

1. Using the internal rate of return method calculate an approximate interest yield for the project. (use tables from Appendix G)
2. Should this project be accepted by Dow Chemical and why?

SHOW ALL COMPUTATIONS PLEASE, ISHOW ALL COMPUTATIONS PLEASE, show all COMPUTATIONS PLEASE,

Answer 1

Answer:

Given information:

Cash Outflow = $ 1,52,000

After tax Cash inflow = S 40,000 per year

Salvage value = 0

Life Span = 5 years

Discounting rate = 9%

A.Calculation of investment's interest yield using internal rate of return method:

IRR is the rate at which the sum of discounted cash inflows is equal to sum of discounted cash outflows. It happens where NPV is Zero.

Cash inflow * Discounting factor = Cash outflow

40,000 * Discounting factor = 1,52,000

Discounting factor = 1,52,000/40,000 = 3.8

If we see for 3.8 in the present value of annuity table for 5 years it comes approx to 10% (the annuity figure at 10% rate of return for 5 years is 3.7908).

Therefore the Interest yield using the IRR method comes to 10%.

B.We can accept the project only when the NPV is positive.

Negative NPV indicates more cash outflow is more than that of present value of cash inflows.

Similar case with IRR,

When the discounting rate is lower than IRR than NPV will remain positive.

But when discounting rate is more than IRR NPV will stand negative which indicates negative cash flows.

So, in the above calculations the IRR is 10% where the actual rate of return is 9% as the interest yield from the project is more than rate of return the project can be accepted by Dow Chemical.