Question

Consider a worker who is offered a salary bonus of $2,000 for each of the next two years (years t = 1 t = 2) if she enrolls in a job training program this year. The total cost to the worker, including any forgone earnings, is $3,500. These costs are borne this year (year t = 0).

1. What is the internal rate of return on this investment?

2. Would this be a good investment for someone with a discount rate of 6%? What is the highest discount rate a person could have and still find this investment attractive?

Answer 1

1. The internal rate of return for this investment would be (without the discount rate given) =

= [{(2000+2000) - 3500} / 3500] * 100

= {(4000 - 3500) / 3500} * 100

= (500/3500) * 100

= 0.1428 * 100

= 14.28%

2. If the discount rate was 6%, IRR would be =

(cash flows) / (1+r)^i - initial investment

where, r = discount rate

and i = time period

= [{2000/ (1+0.06)^1} + {2000/ (1+0.06)^2}] - 3500

= {(2000/1.06) + (2000/1.06^2)} - 3500

= (1886.79 + 2000/1.1236) - 3500

= (1886.79 + 1779.99) - 3500

= 166.78

= 4.7%

This would be a good investment for someone with a discount rate of 6%.

Using trial and error in the same formaula, the highest discount rate at which this investment would still be attractive is 8%. At anything beyond that, internal rate of return would turn negative, thus the value of the investment would be unattractive.