Question

NPV and IRR

Each of the following scenarios is independent. All cash flows are after-tax cash flows.

The present value tables provided in Exhibit 19B.1 and Exhibit 19B.2 must be used to solve the following problems.

Required:

1. Patz Corporation is considering the purchase of a computer-aided manufacturing system. The cash benefits will be $854,000 per year. The system costs $4,559,000 and will last ten years. Compute the NPV assuming a discount rate of 12 percent.
$

Should the company buy the new system?

2. Sterling Wetzel has just invested $224,500 in a restaurant specializing in German food. He expects to receive $34,565 per year for the next eleven years. His cost of capital is 9.45 percent. Compute the internal rate of return. Round your answers to whole percentage value (for example, 16% should be entered as "16" in the answer box).
%

Did Sterling make a good decision?

Answer 1

1).

NPV can be calculated using the formula C0+C1/(1+r)+C2/(1+r)^2+....Cn/(1+r)^n, shere C0 is initial investment, Cn are cash inflows, r is required rate of return and n is the number of periods.

So, -4559000+854000/(1.12)+854000/1.12^2+....854000/1.12^10= -4559000+854000)1.12+854000/1.2544+...854000/3.1058= 266290.47

As the NPV is positive, company should buy the system.

2).

IRR is the interest rate at which NPV is 0.

So, from the given data, -224500+34565/(1+r)+34565/(1+r)^2+....34565/(1+r)^11= 0. On solving, we get IRR=10%

As IRR is greater than his cost of capital of 9.45%, Sterling made a good decision.