Bernard has been approached about a hotel investment proposal by a young entrepr

Question

Bernard has been approached about a hotel investment proposal by a young entrepreneur named Winston. The young man seems to have done his homework and presents Bernard with a five-year pro forma showing cash flows of $128,000, $138,900, $141,250, $142,870 and $146,780 respectively. Bernard knows he can earn an 8% return if he puts his money in a mutual fund. Winston is asking for $500,000.

1. What is the internal rater of return of this project ?

2. Should Bernard invest in this project ?

3. If you assume 8% as the cost of capital, compute net present value.

Shows formula please.

Explanation / Answer

(a) Internal rate of return is a percentage discount rate used in capital investment appraisals which brings the cost of a project and its future cash inflows into equality, i.e. a rate at which the NPV of the investment is Zero.

Computation of Internal Rate of Return :-

Net Present Value at Expected Rate of Return, i.e. 8% is $ 85772.70 and at an higher rate (which is assumed to be 12% here in this question) is $ -333.12.

The Internal Rate of Return = 8% + [85772.70/ (85772.70 - (-333.12))] x (12-8)

=> 8% + [85772.70/ (85772.70 + 333.12)] x 4

=> 8% + [85772.70/ 86105.82] x 4

=> 8% + (0.9961 x 4)

=> 8% + 3.98 = 11.98%

(b) Since, the Internal Rate of Return is higher than the expected rate of return, Bernard should invest in this project.

(c) Net Present Value at 8% :-

Year Cash Flow PVF (n,8%) PV 0 -500000 1.000 -500000.00 1 128000 0.943 120704.00 2 138900 0.890 123621.00 3 141250 0.840 118650.00 4 142870 0.792 113153.04 5 146780 0.747 109644.66 197800 85772.70

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