Question

41.You are analyzing an investment opportunity for your firm. The investment will cost $10,000 to undertake and will produce a cashflow of $2000 at the end of every year for the next 6 years. What is the internal rate of return?

Select one:a. About 4%b. About 4.5%c. About 5%d. About 5.5%e. None of the above.

Answer 1

The IRR is the rate at which NPV is zero.

Lets compute NPV at 5% as shown below:

= - $ 10,000 + $ 2,000 / 1.05 + $ 2,000 / 1.05² + $ 2,000 / 1.05³ + $ 2,000 / 1.05⁴ + $ 2,000 / 1.05⁵ + $ 2,000 / 1.05⁶

= $ 151.3841345

Lets compute NPV at 6% as shown below:

= - $ 10,000 + $ 2,000 / 1.06 + $ 2,000 / 1.06² + $ 2,000 / 1.06³ + $ 2,000 / 1.06⁴ + $ 2,000 / 1.06⁵ + $ 2,000 / 1.06⁶

= - $ 165.351348

It means that the IRR lies between 5% and 6% and is computed as follows:

= Lower rate + [ Lower rate NPV / ( Lower rate NPV - Higher rate NPV ) ] x ( Higher rate - Lower rate)

= 5 + [ $ 151.3841345 / ( $ 151.3841345 - ( - $ 165.351348) ] x ( 6 - 5)

= 5 + [ $ 151.3841345 / $ 316.7354825] x 1

= 5.5% Approximately

So, the correct answer is option d i.e. about 5.5%

Feel free to ask in case of any query relating to this question