Question

Assume you invest $4,500 today in an investment that promises to return $6,250 in exactly 10 years.

a. Use the​ present-value technique to estimate the IRR on this investment.

b. If a minimum annual return of 10% is​ required, would you recommend this​ investment?

Answer 1

Computation of IRR

Both positive as well as negative NPV using trial and error method are needed to compute IRR.

Trial with 10%

Present value of return (Inflow) = 6250*PV factor @10% for 10 years

NPV = Present value of inflow - Outflow

OR

Trial with 3%

Present value of return (Inflow) = 6250*PV factor @3% for 10 years

NPV is positive at 3% and NPV is negative at 10%.

L = Lower discount rate

H = Higher discount rate

NPVL = NPV at Lower discount rate

NPVH = NPV at Higher discount rate

d = Difference between lower and higher discount rate

%

Acceptance criteria on IRR

If the required rate of return is higher than the IRR, reject the project

If the required rate of return is lesser than the IRR, accept the project.

b. If a minimum annual return of 10% is​ required, would you recommend this​ investment?

This​ investment is not recommended.

A project with IRR that exceeds required rate of return (RRR) is said to be profitable.