Question

Anderson International Limited is evaluating a project in Erewhon. The project will create the following cash flows:

Year	Cash Flow
0	–$	1,275,000
1		435,000
2		505,000
3		415,000
4		345,000

All cash flows will occur in Erewhon and are expressed in dollars. In an attempt to improve its economy, the Erewhonian government has declared that all cash flows created by a foreign company are “blocked” and must be reinvested with the government for one year. The reinvestment rate for these funds is 4 percent.

If Anderson uses a required return of 11 percent on this project, what are the NPV and IRR of the project? (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16. Enter your IRR as a percent.)

Answer 1

First, we need to find the future value of the cash flows for the one year in which they are blocked by the government. So, reinvesting each cash inflow for one year, we find:

Year 2 cash flow = Cash Flow(Year 1) * (1 + Reinvestment Rate) = $435,000 * (1 + 0.04) = $452,400

Year 3 cash flow = Cash Flow(Year 2) * (1 + Reinvestment Rate) = $505,000 * (1 + 0.04) = $525,200

Year 4 cash flow = Cash Flow(Year 3) * (1 + Reinvestment Rate) = $415,000 * (1 + 0.04) = $431,600

Year 5 cash flow = Cash Flow(Year 4) * (1 + Reinvestment Rate) = $345,000 * (1 + 0.04) = $358,800

NPV = PV of Cash Inflows - PV of Cash Outflows

= [$452,400 / (1 + 0.11)²] + [$525,200 / (1 + 0.11)³] + [$431,600 / (1 + 0.11)⁴] + [$358,800 / (1 + 0.11)⁵] - $1,275,000

= $367,177.99 + $384,021.71 + $284,308.29 + $212,930.34 - $1,275,000 = -$26,561.67

To find the IRR, we need to put the following values in the financial calculator:

CF0 = -1,275,000; C01 = 0; F01 = 1; C02 = 452,400; F02 = 1; C03 = 525,200; F03 = 1; C04 = 431,600; F04 = 1; C05 = 358,800; F05 = 1; Press IRR, then CPT, which gives, 10.29

So, IRR = 10.29%