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?

	a.	5%
	b.	10%
	c.	15%
	d.	None of these

Answer 1

Answer: b. 10%

Year	Cash flow
0	-4895
1	1500
2	2000
3	2500
IRR =	10.00%

Excel Formula:

Another method: Trial and Error Method

Take two discount rates, say 4% and 16%.

Outflow	4895
Year	Cash flow	Discount Factor at 4%	Discounted Cash flow at 4%	Discount Factor at 16%	Discounted Cash flow at 16%
1	1500	0.96154	1,442.31	0.86207	1,293.10
2	2000	0.92456	1,849.11	0.74316	1,486.33
3	2500	0.88900	2,222.49	0.64066	1,601.64
Total			5,513.91		4,381.07

Here,
L = Lower Rate
H = Higher Rate
DCL = Discounted cash flow at lower rate
DCH = Discounted cash flow at higher rate

Therefore,

Now here is a decimal error, because the rates we took have big difference. Now that we have an idea that it is somewhere near 10.55%, you can select two closer rates, say 9% and 11% and solve. You will get more accurate percentage. But for this problem this is enough.