Your factory has been offered a contract to produce a part for a new printer. The contract would last for three years, and your cash flows from the contract would be $5.04 million per year. Your upfront setup costs to be ready to produce the part would be $8.05 million. Your discount rate for this contract is 7.7%. a. What is the IRR? b. The NPV is $5.01 million, which is positive so the NPV rule says to accept the project. Does the IRR rule agree with the NPV rule?
a)
IRR is the rate of return that makes initial cost equal to present value of cash inflows
Initial investment = annuity * [1 - 1 / (1 + r)n] / r
8,050,000 = 5,040,000 * [1 - 1 / (1 + r)3] / r
Using trial and error method, i.e., after trying various values for R, lets try R as 39.59%
8,050,000 = 5,040,000 * [1 - 1 / (1 + 0.3959)3] / 0.3959
8,050,000 = 5,040,000 * 1.59724
8,050,000 = 8,050,000
Therefore, IRR is 39.59%
b)
project should be accepted as IRR is greater than the cost of capital of 7.7%. Therefore, it does agree with NPV rule
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