A firm evaluates all of its projects by applying the IRR rule. A project under c

Question

A firm evaluates all of its projects by applying the IRR rule. A project under consideration has the following Cash Flow If the required return is 18 percent, what is the IRR for this project? (Round your answer to 2 decimal places. (e.g., 32.16)) Should the firm accept the following project? It will cost $4,500 to acquire a small ice cream cart. Cart sales are expected to be $3,700 a year for five years. After the five years, the cart is expected to be worthless as that is the expected remaining life of the cooling system. What is the payback period of the ice cream cart?

Explanation / Answer

1.

IRR is the discount rate at which NPV = 0

Therefore,

Applying Interpolation we get,

IRR = 15% + [(0+598) / (753+598)] * (15% - 18%) = 13.67 %

The firm should not accept the project as the IRR is less than the required return of 18%

2.

Depreciation per year = (cost - salvage value) / number of useful life = (4500 - 0) / 5 = $900

Cash Inflow from cart sales = $3700 per year for each of the 5 years.

Net profit from the sale icecream per year = $3700 - depreciation = $3700 - $900 = $2800

As depreciation is a non cash expense,

Cash Inflow per year for each of the 5 years = Net profit + Depreciation  = $2800 + $900 = $3700

As the cash inflow is equal in every year,

The payback Period

= Initial Invetment / Cash inflow per year

= $ 4500 / $3700

= 1.22 years

=

year cash flow ($) Discount Factor @18% Discounted Cash Flow ($) Discount Factor @15% Discounted Cash Flow ($) 0 -27800 1.000 -27800 1.000 -27800 1 11800 0.847 10000 0.870 10261 2 14800 0.718 10629 0.756 11191 3 10800 0.609 6573 0.658 7101 NPV -598 753

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