Assume you have $80,000 available for investment and it is currently earning int

Question

Assume you have $80,000 available for investment and it is currently earning interest at an annual compound rate of 10%. Two investment alternatives have become available. One requires investing $80,000 now; the other requires investing $80,000 in 2 years from now, but a commitment is required now if it is to be pursued. In both cases, the investments will terminate 5 years from now. The cash flows for each alternative are shown in the table that follows. Which do you recommend, using internal rate of return and external rate of return comparisons?

Explanation / Answer

a) A returns 108750 while B returns 100000. Since IRR of A = (108750/80000)^(1/5)-1 = 6.33% and IRR of B = (100000/80000)^(1/3)-1= 7.72%, B should be recommended b) After 10% annual interest, A returns 21750*1.1^4+21750*1.1^3+21750*1.1^2+21750*1.1+21750 = 132785.9 while B returns 33333*1.1^2+33333*1.1+33333 = 110332.2 ERR of A = (132785.9/80000)^(1/5)-1=10.067% ERR of B = (110332.2/80000)^(1/3)-1= 11.311% B should be recommended

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