Question

An investment carrying a current cost of $130,000 is going to generate $70,000 of revenue in each of the next three years. To calculate the internal rate of return we need to:

options:

calculate the present value of each of the $70,000 payments and multiply these and set this equal to $130,000.

take the present value of $210,000 for three years from now and set this equal to $130,000.

set the sum of the present value of $70,000 for each of the next three years equal to $130,000.

subtract $130,000 from $210,000 and set this difference equal to the interest rate.

Answer 1

In order to solve this we need to understand what is Internal rate of return

Internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.

So, we need to make the Present value of the future cashflows as zero therefore looking at the options the option (C) which states that ''set the sum of the present value of $70,000 for each of the next three years equal to $130,000" is the correct answer because here we have to set the present values in such a way that it becomes equal to the amount of $ 130,000 which is the cost of the investment.

The other option are wrong as first option says we need to calculate the present value of each of the $70,000 payments and multiply these and set this equal to $130,000 but we donot have to multiply the PV's calculated. So this option is wrong.

Second option says taking present value of 210,000 for 3 years but our revenue is $ 70,000 each year. So this is also wrong

Fourth option says we need to subtract $130,000 from $210,000, this is also wrong as present values will not become zero.

So correct answer is option (C).

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