Question

Sheridan, Inc., a resort management company, is refurbishing one of its hotels at a cost of $8,760,702. Management expects that this will lead to additional cash flows of $1,988,000 for the next six years. What is the IRR of this project? If the appropriate cost of capital is 12 percent, should Sheridan go ahead with this project?

Answer 1

We can use following formula to calculate internal rate of return (IRR)

Sum of [cash flows/ (1+IRR) ^t] - initial cash outflow = 0

Where,

Initial Outflow of Cash = -$8,760,702

Cash flows from year 1 to year 6 = $1,988,000 per year

Internal Rate of Return is IRR =?

Therefore

$1,988,000/ (1+IRR) ^1 + $1,988,000/ (1+IRR) ^2 + $1,988,000/ (1+IRR) ^3 + $1,988,000/ (1+IRR) ^4 + $1,988,000/ (1+IRR) ^5 + $1,988,000/ (1+IRR) ^6 - $8,760,702 = 0

By trial and error method, we get

The internal rate of return (IRR) of project = 9.60%

Internal Rate of return (IRR) of this project is 9.60%; as the IRR is less than the appropriate cost of capital of 12% therefore this project is not acceptable.