Question

A firm is evaluating whether to build a new factory. The proposed investment will cost the firm $1 million to construct and provide cash savings of $200,000 per year over the next 10 years.

(1) What rate of return does the investment offer?

(2) What is the maximum risk-free rate under which the firm is willing to make this investment?

(3) If the firm were to invest another $500,000 in the facility at the end of 5 years, it would extend the life of the project for 4 years, during which time it would continue receiving cash savings of $150,000. What is the internal rate of return for this additional investment?

Answer 1

	.(1)	Return on Investment
	A	Investment	$1,000,000
	B	Cash Savings per year	$200,000
	R=B/A	Return on Investment	0.2
		Return on Investment	20%
	.(2)	Maximum Risk Free Rate:
	Nper	Number of years	10
	Pv	Investment	$1,000,000
	Pmt	Cash Savings per year	$200,000
	RATE	Maximum Risk Free Rate:	15.10%
		(Using RATE function of excel)
	.(3)	Internal Rate of Return
			Year	Cash Flow
			0	($1,000,000)
			1	$200,000
			2	$200,000
			3	$200,000
			4	$200,000
			5	($300,000)	(200000-500000)
			6	$200,000
			7	$200,000
			8	$200,000
			9	$200,000
			10	$200,000
			11	$200,000
			12	$200,000
			13	$200,000
			14	$200,000
		INTERNAL RATE OF RETURN	12.79%
		(Using IRR function of excel)