INTERNAL RATE OF RETURN (Even Cash Flows)Background: What does the IRR method pr
ID: 2466808 • Letter: I
Question
INTERNAL RATE OF RETURN (Even Cash Flows)Background: What does the IRR method provide?Action Plan: What is the formula for the internal rate of return? What else must be done to determinethe IRR?
1. First, the present value of an annuity factor (PVA) must be calculated: PVA factor = Net initial investment (Cost – salvage value of old asset)/ annual cash flow2. Then, the PVA factor must be looked up in the table using the life of the investment. Find the
column that the factor is in, that is the IRR.
Solve: Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 peryear in cash operating costs. The machine will have a 10-year life; the company's cost of capital(discount rate) is 12%. What is the machine's IRR?
Evaluate: What does the answer mean? Is the project acceptable? Why?
Explanation / Answer
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Cash outlflow -104,320 Saving per year - 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 Cash Inflow -Net -104,320 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 Discount rate @ 10% 1.000 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 PV of Cash Inflow -104,320 17,857 15,944 14,236 12,710 11,349 10,133 9,047 8,078 7,212 6,439 Cummulative Cash inflow -104,320 -86,463 -70,519 -56,283 -43,573 -32,224 -22,092 -13,045 -4,967 2,245 8,684 Possitive value of Cash flow 113,004 NPV of Machine 8,684 IRR of Machine sqrt ( 113004/104320)-1 = 4.08% IRR of the machine is only 4.08% whereas cost of capital is 12%. Therefore it is not suggested to invest in the machine.
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