Question

A project that provides annual cash flows of $24,000 for 9 years costs $110,000 today. Under the IRR decision rule, is this a good project if the required return is 8 percent?

Answer 1

Answer:

IRR (22%) is greater than the required rate of return of 8%, so we accept te project for implementation.

The project is good.

Explanation:

The IRR is the discount rate that equates the present value of cash inflows to that of cash outflows. At the IRR, the Net Present Value (NPV) of a project is equal to zero

If the IRR greater than the required rate of return , we accept the project for implementation

If the IRR is less than that the required rate , we reject the project for implementation

Lets calculate the IRR

Step 1: Use the given discount rate of 8% and work out the NPV

NPV = 24,000×  (1-(1.08)^(-9))/0.08 )  -   110,000

       =  (24,000 × 6.2468) - 110,000

     =  39,925.31

Step 2 : Use  discount rate of 40% and work out the NPV (40% is a trial figure)

   NPV = 24,000 ×  (1-(1.4)^(-9)/0.4)  -  110,000

    = (24,000 ×  2.3789) - 110,000

   =  (52,904.02)

Step 3: calculate IRR

         = 8% + ( (39,925.31/(39,925.31+52,904.02) )× (40%-8%)

   = 22%

Step 4 : compare the IRR(22%) to 8% and make decision

IRR (22%) is greater than the required rate of return of 8%, so we accept the project for implementation.

That is the project is good.