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Capital Budgeting-IRR

The company is considering investing in a machine costing $100,000. It has a 10 year life span, and no salvage value. Annual maintenance costs are $10,000pa, and labour savings are $25,000pa.

Ignore tax effects.

a. If all cash flows occur at the end of each year, what rate of return can be expected?
b. If all cash flows occur at the beginning of each year, what rate of return can be expected?
c.Why is there a difference (if any)?
d. What is another name forthis rate of return which, used as a discount rate, would result in a zero NPV?
e. After calculating this rate of return, how would you know whether this project will result in the maximisation of shareholder wealth?
f. Discuss the limitations of this type of rate of return, when used for the analysis of capital budgeting projects.

Solution Preview

The company is considering investing in a machine costing $100,000.
It has a 10 year life span,a nd no salvage value.
Annual maintenance costs are $10,000pa, and labour savings are $25,000pa.
Ignore tax effects.

Note:
PVIFA= Present Value Interest Factor for an Annuity
It can be read from tables or calculated using the following equations
PVIFA( n, r%)= =[1-1/(1+r%)^n]/r%

a. If all cash flows occur at the end of each year, what rate of return can be expected?

Cash flow at time 0= -$100,000 (negative since it is an outflow)
Cash flow at time 1-10= $15,000 =25000-10000

To calculate the rate of return, we use the fact that the discounted cash flow (discounted at the rate of return) for periods 1 to 10 should be equal to the initial outlay

PVIFA (r%, 10 years) x $15,000 = $100,000
or PVIFA (r%, 10 years) = 6.6667 =100000/15000

Looking up the tablePVIFA tables and interpolating or through trial and error, this corresponds to
r= 8.14%

n= 10
r= 8.14%
PVIFA (10 periods, 8.14% rate ) = 6.6679
which is close to ...

Solution Summary

Carries out IRR calculations

$2.19