Answer to Question #310659 in Finance for Aaa

Question

Rahman is considering to independent projects, Project A and Project B. The

initial cash outlay associated with Project A is RM50,000 and the project

would generate cash flows of RM12,000 per year for six years. While the

initial outlay for Project B would be RM70,000 with generate cash flows of

RM13,000 per year for ten years. The discount rate on both projects is 12

percent. Calculate Internal Rate of Return (IRR) for each project and indicate

if the project should be accepted or not

Answer 1

$IRR=\frac{PVCOF}{A}$

Project A

Initial investment for project A is RM50,000

IRR=$\frac{50000}{12000}$ =4.1667

Check 4.1667 in the annuity table under the 6^th year.

It falls between 10%@ 4.3553 and 12%@4.1114

$\frac{IRR-Lower limit}{Upper limit-Lower limit}$

$\frac{IRR-10}{12-10}$=$\frac{4.1667-4.3553}{4.1114-4.3553}$

$\frac{IRR-10}{2}$ =0.7733

IRR=11.55$\%$

PROJECT B

Initial investment is RM 70,000

Cashflows RM13,000 for 10 years

IRR=$\frac{70,000}{13,000}$ =5.3846

5.3846 under 10^th year from the annuity table;

Falls between14$\%$ @5.2161and 12$\%$ @5.6502

$\frac{IRR-12}{14-12}$=$\frac{5.3846-5.6502}{5.2161-5.65002}$

$\frac{IRR-12}{2}$=0.6118

IRR=13.22$\%$

Decision criteria

Cost of capital of capital is12$\%$

If:

IRR<cost of capital, reject the project

IRR>Cost of capital, accept the project

IRR=Cost of capital, investor is indifference

IRR for project A is 11.55$\%$ which is less than the cost of capital and this implies that we should reject the project.

IRR for project B is 13.22$\%$ which is greater than the cost of capital. Therefore, we should accept the project.