Question

Suppose that you are offered an investment at cost of 800. That investment will pay the following cash flows.

0. 1. 2. 3. 4. 5

0. 500. 400. 300. 200. 100

A) should you make the investment if the required rate of return is 12% per year? why? explain.

B) What is the internal rate of return of this cash flow stream? if you require a rate of return of 12% annually. Should you make the investment? Why? explain.

Answer 1

1)

We need to find the net present value

NPV = Present value of cash inflows - presnet value of cash outflows

NPV = -800 + 500 / (1 + 0.12)^1 + 400 / (1 + 0.12)^2 + 300 / (1 + 0.12)^3 + 200 / (1 + 0.12)^4 + 100 / (1 + 0.12)^5

NPV = -800 + 446.42857 + 318.87755 + 213.534074 + 127.10362 + 56.7427

NPV = $362.69

The investment should be made because it has a positive NPV. A positive NPV will increase your net worth. Here, it will increase your net worth by $362.69

2)

Internal rate of return = 34.50%

Investment should be made because the IRR is greater than the required return of 12%.