Question

Your company plans to make a new chip. They analyze the project and find that the next income of the project is $77,408 per year for the next 5 years.The net investment is $1,000,000. This investment will be fully depreciated to a zero book value on a straight-line basis over 5 years. The firm's cost capital is 10%. Determine the internal rate of return (IRR).

Answer 1

IRR is a metric used in capital budgeting to estimate the profitability of potential investments. IRR is the discount rate that makes NPV of the project equal to 0. If IRR > cost of capital, we select the project and vice versa.

We are given,

Net income = $77,408 for 5 yeras.

Initial outflow = $1,000,000

Depreciation = 1,000,000/5 = $200,000 per year.

Net cash flow = 77,408 + 200,000 = $277,408

Depreciation is a non-cash expense. It reduces the amount of taxes paid by the firm. Hence it is added back to the net income.

0 = NPV = ∑​ CF / (1+IRR)^t ​​− C0​

We can also calculate IRR in excel,

Yr	CF	Discounting factor	Present value of cash flows
0	-1000000	1.000	-1,000,000
1	277408	0.909	252189
2	277408	0.826	229263
3	277408	0.751	208421
4	277408	0.683	189473
5	277408	0.621	172249
		NPV	51594.6
		IRR	12.00%

As IRR > cost of capital (12>10), we will accept the project.

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