IRR IRR The ABC Company Ltd plans to create a business. There are two potential
ID: 2395643 • Letter: I
Question
IRR IRR The ABC Company Ltd plans to create a business. There are two potential business options namely business D and E. Data pertaining to investment requirements and payoffs is given in the table below. All financial data are in Tshs. Item First cost Option D 50M OptionE 40M Annual maintenance|2M and to increase by 200,000 from year 2 2 M between year 5 and ye ar costs Salvage value Life span - years and thereafter 15M 20 10M 20 10M Annual revenue Which option is worth pursuing? Use an internal rate of return method.Explanation / Answer
IRR for Option D is 24.23 % and that of Option E is 23.15 %
Hence based on IRR decision, Option D is worth purchasing.
Explanation
Cash flows for Option D:
For year 1:
Cash flow = Annual revenue – annual maintenance costs = 15,000,000 – 2,000,000 = 13,000,000
For year 2:
Cash flow = Annual revenue – annual maintenance costs = 15,000,000 – (2,000,000 + 200,000)
= 15,000,000 – 2,200,000 = 12,800,000
For year 3:
Cash flow = Annual revenue – annual maintenance costs = 15,000,000 – (2,200,000 + 200,000)
= 15,000,000 – 2,400,000 = 12,600,000
And so on…
For year 20:
Cash flow = Annual revenue + salvage value – annual maintenance costs
= 15,000,000 +15,000,000 – [2,000,000 + (200,000 x 19)]
= 30,000,000 – (2,000,000 + 3,800,000)
= 30,000,000 – 5,800,000 = 24,200,000
Cash flow for Option E:
For year 1 to 4 and 11 to 19, cash flow = 10,000,000
For year 5 -10:
Cash flow = Annual revenue – annual maintenance costs = 10,000,000 – 2,000,000 = 8,000,000
For year 20:
Cash flow = Annual revenue + salvage value
= 10,000,000 +10,000,000
= 20,000,000
Computation of IRR:
A
B
C
1
Year
Option D
Option E
2
Cash Flow
Cash Flow
3
0
(50,000,000)
(40,000,000)
4
1
13,000,000
10,000,000
5
2
12,800,000
10,000,000
6
3
12,600,000
10,000,000
7
4
12,400,000
10,000,000
8
5
12,200,000
8,000,000
9
6
12,000,000
8,000,000
10
7
11,800,000
8,000,000
11
8
11,600,000
8,000,000
12
9
11,400,000
8,000,000
13
10
11,200,000
8,000,000
14
11
11,000,000
10,000,000
15
12
10,800,000
10,000,000
16
13
10,600,000
10,000,000
17
14
10,400,000
10,000,000
18
15
10,200,000
10,000,000
19
16
10,000,000
10,000,000
20
17
9,800,000
10,000,000
21
18
9,600,000
10,000,000
22
19
9,400,000
10,000,000
23
20
24,200,000
20,000,000
24
IRR
24.23%
23.15%
Excel Formula for IRR of Option D: “=IRR(C3:C23)
Excel Formula for IRR of Option E: “=IRR(D3:D23)
A
B
C
1
Year
Option D
Option E
2
Cash Flow
Cash Flow
3
0
(50,000,000)
(40,000,000)
4
1
13,000,000
10,000,000
5
2
12,800,000
10,000,000
6
3
12,600,000
10,000,000
7
4
12,400,000
10,000,000
8
5
12,200,000
8,000,000
9
6
12,000,000
8,000,000
10
7
11,800,000
8,000,000
11
8
11,600,000
8,000,000
12
9
11,400,000
8,000,000
13
10
11,200,000
8,000,000
14
11
11,000,000
10,000,000
15
12
10,800,000
10,000,000
16
13
10,600,000
10,000,000
17
14
10,400,000
10,000,000
18
15
10,200,000
10,000,000
19
16
10,000,000
10,000,000
20
17
9,800,000
10,000,000
21
18
9,600,000
10,000,000
22
19
9,400,000
10,000,000
23
20
24,200,000
20,000,000
24
IRR
24.23%
23.15%
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