Question

Suppose your firm is considering investing in a project with the cash flows shown as follows, that the required rate of return on projects of this risk class is 10 percent, and that the maximum allowable payback and discounted payback statistics for the project are three and a half and four and a half years, respectively. Use the IRR decision to evaluate this project; should it be accepted or rejected?

Time	0	1	2	3	4	5	6
Cash Flow	-85000	12000	11000	13000	21000	31000	32000

A: IRR = 16.92 percent, accept the project

B: IRR = 7.123 percent, reject the project

C: IRR = 8.81 percent, reject the project

D: IRR = 10.59 percent, accept the project

Answer 1

First we will calculate Npv of project at 8% discount rate

Npv is present value of cash flows less initial investment

P.v of cash flows is

12000/(1.08) + 11000/(1.08)^2 + 13000/(1.08)^3 + 21000/(1.08)^4 +31000/(1.08)^5+32000/1.08)^6 = 87560

Less initial investment is 85000

Npv is 2560

Now Npv at 10% rate is

=12000/(1.1)+11000/(1.1)^2+13000/(1.1)^3+21000/(1.1)^4+31000/(1.1)^5+32000/1.1^6 -85000

= -3578

Now IRR shall be calculated by using interpolation method

Formula is

Lower rate +[ NPV at lower rate / (NPV at lower rate - NPV at higher rate)] * ( Higher rate - Lowe rate)

= 8% +(2560)×(10-8)/(2560-(-3578)

IRR is 8.81%

As IRR is less than expected return project shall be rejected

So correct answer is C