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Chapter 26: Q28RQ (page 1464)

What is the decision rule for IRR?

Short Answer

Expert verified

Answer

According to the IRR rule, a project or investment can be pursued if the IRR is higher than the required rate of return, which is often the cost of capital. The best course of action might be to reject a project or investment if, on the other hand, the IRR is less than the cost of capital.

Step by step solution

01

Definition

In financial analysis, the internal rate of return (IRR) is a statistic used to calculate the profitability of possible investments. IRR is a discount rate that, in a discounted cash flow analysis, reduces all cash flows' net present values (NPV) to zero.

02

Calculation

IRR is calculated by,

IRR = [(Cash flows) / (1+r)^i ] 鈥� Initial investment

Where;

Cash flows = cash flows in the time period

r = Discount rate

i = Time period

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Most popular questions from this chapter

Calculate the present value of the following future cash flows, rounding all calculations to the nearest dollar.

11. \(5,000 received in three years with interest of 10%

12. \)5,000 received in each of the following three years with interest of 10%

13. Payments of \(2,000, \)3,000, and $4,000 received in years 1, 2, and 3, respectively, with interest of 7%

Use the NPV method to determine whether Hawkins Products should invest in the

following projects:

鈥� Project A: Costs \(285,000 and offers seven annual net cash inflows of \)55,000. Hawkins Products requires an annual return of 14% on investments of this nature.

鈥� Project B: Costs \(395,000 and offers 10 annual net cash inflows of \)77,000. Hawkins Products demands an annual return of 12% on investments of this nature.

Requirements

1. What is the NPV of each project? Assume neither project has a residual value. Round to two decimal places.

2. What is the maximum acceptable price to pay for each project?

3. What is the profitability index of each project? Round to two decimal places.

Question: Using payback to make capital investment decisions Consider the following three projects. All three have an initial investment of \(800,000.

Net Cash Inflows

Project LProject MProject N

Year

Annual

Accumulated

Annual

Accumulated

Annual

Accumulated

1

\) 100,000

\( 100,000

\)

200,000

\( 200,000

\)

400,000

$ 400,000

2

100,000

200,000

250,000

450,000

400,000

800,000

3

100,000

300,000

350,000

800,000

4

100,000

400,000

400,000

1,200,000

5

100,000

500,000

500,000

1,700,000

6

100,000

600,000

7

100,000

700,000

8

100,000

800,000

Requirements

  1. Determine the payback period of each project. Rank the projects from most desirable to least desirable based on payback.
  2. Are there other factors that should be considered in addition to the payback period?

What is the accounting rate of return?

Henderson Manufacturing, Inc. has a manufacturing machine that needs attention. The company is considering two options. Option 1 is to refurbish the current machineat a cost of \(1,200,000. If refurbished, Henderson expects the machine to last anothereight years and then have no residual value. Option 2 is to replace the machine at acost of \)4,600,000. A new machine would last 10 years and have no residual value.Henderson expects the following net cash inflows from the two options:

YearRefurbish CurrentPurchase New

MachineMachine

1 \( 350,000 \) 3,780,000

2 340,000 510,000

3 270,000 440,000

4 200,000 370,000

5 130,000 300,000

6 130,000 300,000

7 130,000 300,000

8 130,000 300,000

9 300,000

10 300,000

Total \( 1,680,000 \) 6,900,000

Henderson uses straight-line depreciation and requires an annual return of 10%.

Requirements

1. Compute the payback, the ARR, the NPV, and the profitability index of these twooptions.

2. Which option should Henderson choose? Why?
See all solutions

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