question archive P10–16 Long-term investment decision, IRR method Billy and Mandy Jones have $25,000 to invest
P10–16 Long-term investment decision, IRR method Billy and Mandy Jones have $25,000 to invest
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P10–16 Long-term investment decision, IRR method Billy and Mandy Jones have $25,000 to invest. On average, they do not make any investment that will not return at least 7.5% per year. They have been approached with an investment opportunity that requires $25,000 upfront and has a payout of $6,000 at the end of each of the next 5 years. Using the internal rate of return (IRR) method and their requirements, determine whether Billy and Mandy should undertake the investment.
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Cash flow at year 1 = $ 6000
Cash flow at year 2 = $ 6000
Cash flow at year 3 = $ 6000
Cash flow at year 4 = $ 6000
Cash flow at year 5 = $ 6000
For IRR, NPV = 0
Initial investment + PV of all future cashflows = 0
-$25,000 + $6,000/(1+r)^1 + $6,000/(1+r)^2 + $6,000/(1+r)^3 + $6,000/(1+r)^4 + $6,000/(1+r)^5) = 0
Solving this the value of r comes out to be approx 6.402.
Thus, the IRR is 6.402% approx.
Billy and Mandy will note undertake this investment because the required rate of return by them is 7.5% and this project is giving 6.402% that is less than 7.5%.
