Question

18. You are considering investing in a small business that would generate the following cash flows:
year 1 = 60,000 (loss)
year 2 = 75,000 (loss)
year 3 = +$100,000
year 4 = +$150,000

The ownership position would cost you $1,800,000 up front but you think you can sell it for $2,550,000 after 4 years. Your investment hurdle rate for this kind of investment is 10%. Which of the following is accurate and appropriate when looking at this opportunity from strictly a financial point of view?

• Don’t make the investment as the IRR cannot be calculated from the data above.
• Make the investment if the IRR is greater than the cap rate by at least the risk-free rate.
• Don’t make the investment as the projected IRR is 8.72%.
• Make the investment as the projected IRR is 10.04%.

Answer 1

The cashflow is:

1	A	B
2	Year 0	-$1,800,000
3	Year 1	-$60,000
4	Year 2	-$75,000
5	Year 3	$100,000
6	Year 4	$2,700,000 (=2,550,000 + 150,000)

IRR (Internal rate of return) is rate of return of a given cashflow such that the NPV would be zero. We can then compare the IRR of a cashflow with the hurdle rate (which is the minimum return that is expected from the investment). From a financial point of view, we should go ahead with the investment only if IRR > Hurdle Rate.

In this case, we calculate the IRR using the Excel formula =IRR(B2:B6). We get IRR as 10.04%

Since the investment hurdle rate is 10% which is less than the IRR (10.04%), it is prudent to invest in the small business.

Thus, d) "Make the investment as the projected IRR is 10.04%". is correct