Question

King’s Department store is analyzing the purchase of manufacturing equipment that will cost $40,000. The annual cash inflows for the next three years will be, $20,000, $18,000, and $13,000. Calculate the internal rate of return (IRR) for this investment. b. If the company’s cost of capital is 12%, should the equipment be purchased? Why or why not

Answer 1

IRR is the rate at which NPV = 0

NPV = present value of cash inflows - present value of cash outflows

Using hit and trial method, NPV at 12% = 20,000/(1.12)+ 18000/(1.12)^2 + 13000/(1.12)^3 - 40,000

= $1,459.78

NPV at 14% = 20,000/(1.14)+ 18000/(1.14)^2 + 13000/(1.14)^3 - 40,000

= $168.90

At 15% = 20,000/(1.15)+ 18000/(1.15)^2 + 13000/(1.15)^3 - 40,000

= -$450.40

Using interpolation, IRR = 14% + (168.90-0)/(168.90+450.40)

= 14.2727%

i.e. 14.28%

Yes, should be purchased since IRR is higher than the cost of capital