Question

You are looking to expand your business by buying the exclusive rights for aircraft engine repair in your home airport. After doing your due diligence, you figure that this opportunity presents the following cash flows:

Up-front cost = $5,000,000      yearly cash flows (growing at 3% per year forever) = $600,000

Your opportunity cost of capital for this investment is 14%. What are the NPV and IRR?  Should you expand into the engine repair business

Answer 1

Solution :-

For the Calculation of NPV

NPV = Present Value of Cash Inflows - Upfront Cost

Upfront Cost = $5,000,000

Annual Cash flows = $600,000

Growth Rate = 3%

Discount Rate = 14%

Now Present Value of Cash flows = $600,000 / ( 0.14 - 0.03 ) = $600,000 / 0.11 = $5,454,545

Therefore NPV = Present Value of Cash flows - Upfront Cost = $5,454,545 - $5,000,000 = $454,545

For the Calculation of IRR

IRR is the rate at which present value of Cash inflows is equal to Present Value of Cash Outflows

Upfront Cost = $5,000,000

Annual Cash flows = $600,000

Growth Rate = 3%

Discount Rate = ?? ( X )

Now Present Value of Cash flows = $600,000 / ( X - 0.03 ) = $5,000,000

Now ( X - 0.03 ) = 0.12

Now X = 0.15 = 15%

Therefore IRR = 15%

Now as the NPV is greater than equal to Zero and IRR is Greater than Greater than Discount Rate

So Accept the Project .

If there is any doubt please ask in comments