Question

You are considering a project which has a set up cost of $4,895, and which yields $1,500, $2,000, and $2,500 at the end of the first, second, and third years after set-up. What is the internal rate of return on this project (Hint: trial and error)

	a.	5%
	b.	10%
	c.	15%

Answer 1

Calculation of IRR :
IRR is the rate at which the PV of Cash Inflows = PV of cash outflows i.e NPV of the project is 0.
[CF1/(1+IRR)1] + [CF2/(1+IRR)2] + [CF3/(1+IRR)3] + - CF0 = 0

We have,

CF0 = -$4895
CF1 = $1,500
CF2 = $2,000
CF3 = $2,500

We have to find out the discounting rate at which NPV of the project is 0.

ASSUMING IRR TO BE 5.00% AND COMPUTING


Since NPV is positive at discount rate of 5%, IRR should be more than 5%.

ASSUMING IRR TO BE 10.00% AND COMPUTING

Since NPV is almost zero at discount rate of 10.00%, IRR is 10.00%.

Note : Present Value Factor have been calculated as = (1/1+r)n

Where
r= Required rate of Return (Discount rate)
n= No of Periods

Option b) is correct.