Question

Thompson Manufacturing is considering two investment proposals. The first involves a quality improvement project, and the second is about an advertising campaign. The cash flows associated with each project appear below:
Quality Improvement Advertising Campaign
Intial cash inflow 100,000 100,000
Cash inflows
Year 1 10,000 80,000
Year 2 30,000 45,000
Year 3 125,000 10,000
Suppose the hurdle rate of the firm is 10%. Calculate the cash inflows of the "incremental project" by subtracting the cash flows of the second project from the cash flows of the first project. What is the IRR of the incremental project?

Answer 1

Answer:

17.9%

Explanation:

The computation of the internal rate of return of the project is shown below;

Year  0          0

Year 1        -70,000 ($10,000 - $70,000)

Year 2       -15,000 ($30,000 - $45,000)

Year 3       115,000 ($125,000 - $10,000)

Let us assume r represent the IRR of the incremental project.

so,  

-$70,000 ÷ (1+r) - $15,000 ÷ (1+r)^2 + $115,000 ÷ (1+r)^3 = 0

r = 17.9%