Question

Professor Wendy Smith has been offered the following​ opportunity: A law firm would like to retain her for an upfront payment of $ 50, 000. In​ return, for the next year the firm would have access to eight hours of her time every month. As an alternative payment​ arrangement, the firm would pay Professor​ Smith's hourly rate for the eight hours each month. ​ Smith's rate is $ 550 per hour and her opportunity cost of capital is 15 % per year.

What does the IRR rule advise regarding the payment​ arrangement? (Hint: Find the monthly rate that will yield an effective annual rate of 15 %​.)

What about the NPV​ rule?

Answer 1

IRR can be calculated using the financial calculator, I/Y will be the value

N= 12 , PMT = 550*8 = $4400( $550 per hour for 8 hours), PV = -$50000 , FV = 0

Put all these values in the financial calculator

I/y = 0.84% ( This is the monthly figure)

Annual IRR = (1.008484)^12= 1.106696 = EAR of 10.67%

IRR is less than her opportunity cost of capital so she should ask for upfront payment

NPV can be calculated using the PV function in the financial calculator

N= 12, I/Y = 15/12%(given), PMT = $4400, FV= 0

Put all these values in financial calculator

We get PV = 1010.96$

which is positive correct decision is to accept the deal.