Question

XYZ company is considering investing in Project Q or Project U. Project Q generates the following cash flows: year “zero” = 281 dollars (outflow); year 1 = 211 dollars (inflow); year 2 = 330 dollars (inflow); year 3 = 318 dollars (inflow); year 4 = 196 dollars (inflow). Project U generates the following cash flows: year “zero” = 230 dollars (outflow); year 1 = 150 dollars (inflow); year 2 = 105 dollars (inflow); year 3 = 201 dollars (inflow); year 4 = 110 dollars (inflow). The MARR is 6%. Compute the External Rate of Return (ERR) of the BEST project. (note1: if your answer is 10.25% then write 10.25 as your answer, not 0.1025) (note2: round your answer to two decimal places, and do not include spaces, currency signs, plus or minus signs, or commas)

Answer 1

We will solve it by using a simple table.

Project Q

Years	inflow/(outflow)	Future values of inflows invested @MARR =6%
0	(281)	n/a
1	211	211* (1.06)3=251.304
2	330	330*(1.06)2=370.79
3	318	318*(1.06)1=337.08
4	196	196*(1.06)0=196
		Total Future value of Inflow = 1155.17

So now we have to equate the present value of outflow to the future value of inflow considering an external rate of return which we have to find out

281 (1+ERR)4=1155.17

(1+ERR)4=4.11

(1+ERR) = 1.424

ERR = 0.424 or 42%

Project U

Years	inflow/(outflow)	Future values of inflows invested @MARR =6%
0	(230)	n/a
1	150	150* (1.06)3=178.65
2	105	105*(1.06)2=117.99
3	201	201*(1.06)1=213.06
4	110	110*(1.06)0=110
		Total Future value of Inflow = 619.7

So now we have to equate the present value of outflow to the future value of inflow considering an external rate of return which we have to find out

230 (1+ERR)4=619.7

(1+ERR)4=  2.69

(1+ERR) = 1.28

ERR = 0.28 or 28%

So the best project is project Q with greater ERR