Question

Suzanne’s Restaurant Supplies is considering the purchase of manufacturing equipment that will cost $20,000. The annual cash inflows for the next three years will be:

Year Cash Flow

1 $10,000

2 $9,000

3 $6,500

A. Determine the internal rate of return

B. With a cost capital of 12%, should the machine be purchased?

Answer 1

cost of capital, WACC, (R)= 12% = 0.12

Cash flow for year 1, C1 = $10,000

Cash flow for year 2, C2 = $9000

Cash flow for year 3, C3 = $6500

Initial Investment , I = 20,000

IRR is the rate of return for which NPV = 0

NPV = Present value of cash inflows of the project - initial investment

Putting NPV = 0

Present value of cash inflows of the project = initial investment

[ (C1/(1+IRR)¹) + (C2/(1+IRR)²) + (C3/(1+IRR)³) ] = I

[ (10,000/(1+IRR)¹) + (9000/(1+IRR)²) + (6500/(1+IRR)³) ] = 20,000

We have to find IRR by trial and error method

by assuming any value and substituting the assumed value in the above equation

we want IRR such that

Left Hand side of equation(LHS) = Right hand side of equation (RHS) = 20,000

by following this method we find that for IRR = 14.27%

B)

since IRR > cost of capital , the machine should be purchased