Tressor Company is considering a 5-year project. The company plans to invest $90,000 now, and it forecasts cash flows for each year of $27,000. The company requires that investments yield a discount rate of at least 14%. Selected factors for a present value of an annuity of $1 for five years are shown below: Interest rate Present value of an annuity of $1 factor for year 510% 3.790812% 3.604814% 3.4331Calculate the internal rate of return to determine whether it should accept this project.
Question
Tressor Company is considering a 5-year project. The company plans to invest 27,000. The company requires that investments yield a discount rate of at least 14%. Selected factors for a present value of an annuity of 1 factor for year 510% 3.790812% 3.604814% 3.4331Calculate the internal rate of return to determine whether it should accept this project.
Solution
To calculate the Internal Rate of Return (IRR), we first need to understand that the IRR is the discount rate that makes the Net Present Value (NPV) of a project zero.
Here are the steps to calculate the IRR:
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Calculate the total present value of the future cash flows. This is done by multiplying the annual cash flow by the present value of an annuity factor.
In this case, the annual cash flow is 27,000 * 3.4331 = $92,693.7
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Subtract the initial investment from the total present value of future cash flows to calculate the Net Present Value (NPV).
In this case, the initial investment is 92,693.7 - 2,693.7
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If the NPV is positive, the IRR is greater than the discount rate. If the NPV is negative, the IRR is less than the discount rate. If the NPV is zero, the IRR is equal to the discount rate.
In this case, the NPV is positive, so the IRR is greater than 14%.
Therefore, Tressor Company should accept this project because the IRR is greater than the required discount rate of 14%.
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