TOPIC: Project evaluation, question: Find Internal Rate of Return (IRR). Objecti

Question

TOPIC: Project evaluation, question: Find Internal Rate of Return (IRR).

Objectives: . to gain experience in financial evaluation of projects . to develop skills in interpreting the results of financial evaluation of projects 1.George & Co. are setting up a subsidiary. The expected life of the plant for this subsidiary is six years, with the residual value at the end of this time being only sufficient to cover removal costs. The total cost of the plant is $3,800,000 with $2,800,000 spent at the beginning of the first year, $900,000 spent at the beginning of the second year, and $100,000 spent at the beginning of the third year. The running costs are estimated to be $5,790,000, $11,120,000, $12,740,000, $11,120,000, $8,100,000 and $4,690,000 in the six years of the project. The sales revenues are projected to be $6,000,000, $13,000,000, $15,000,000 $13,000,000, $10,000,000 and $5,000,000 in each of the six years of the project. Because of the need to pay costs before income is received, there must be injections of working capital. At the start of the project $100,000 is to be set aside for wages, stock and petty cash. A further $1,550,000 will need to be injected at the end of the first year; $1,870,000 at the end of year two; and, $510,000 at the end of the third year. This working capital is reduced at the ends of years 4, 5 and 6 by $510,000, $820,000 and $2,700,000, respectively. The final amount of $2,700,000 assumes all stocks are used up and all customer and supplier accounts are settled Note that the sum of these changes in working capital is zero over the life of the project. The company income tax rate can be taken as 30% of the operating profit. It may be assumed that $2,000,000 of the required capital funds were provided through a loan with an interest rate of 7%. The remainder of the funds will be covered from reserves

Explanation / Answer

Year Cash Outflow NWC OCF Total OCF 0 $    (2,800,000) $    (100,000) $    (2,900,000) 1 $       (900,000) $ (1,550,000) $   287,000.00 $    (2,163,000) 2 $       (100,000) $ (1,870,000) $1,510,000.00 $       (460,000) 3 $    (510,000) $1,783,500.00 $     1,273,500 4 $     510,000 $1,517,500.00 $     2,027,500 5 $     820,000 $1,531,500.00 $     2,351,500 6 $ 2,700,000 $   418,500.00 $     3,118,500 Ans a IRR 11.54% IRR(E2:E8) b Yes IRR is higher than 10% OCF sales Running Cost Depreciation Operating Profit Tax Profit after tax Add back Deprn $ 6,000,000 $     5,790,000 $466,666.67 $       (256,667) $        (77,000) $    (179,667) $    287,000.00 $13,000,000 $   11,120,000 $646,666.67 $     1,233,333 $        370,000 $     863,333 $ 1,510,000.00 $15,000,000 $   12,740,000 $671,666.67 $     1,588,333 $        476,500 $ 1,111,833 $ 1,783,500.00 $13,000,000 $   11,120,000 $671,666.67 $     1,208,333 $        362,500 $     845,833 $ 1,517,500.00 $10,000,000 $     8,100,000 $671,666.67 $     1,228,333 $        368,500 $     859,833 $ 1,531,500.00 $ 5,000,000 $     4,690,000 $671,666.67 $       (361,667) $       (108,500) $    (253,167) $    418,500.00 Depreciation Schedule 1 $2,800,000.00 $2,800,000.00 $ 466,666.67 2 $2,333,333.33 $900,000.00 $3,233,333.33 $ 646,666.67 3 $2,586,666.67 $   100,000.00 $2,686,666.67 $ 671,666.67 4 $2,015,000.00 $2,015,000.00 $ 671,666.67 5 $1,343,333.33 $1,343,333.33 $ 671,666.67 6 $   671,666.67 $   671,666.67 $ 671,666.67

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