This exercise illustrates the use of internal rate of return (IRR) method to evaluate an investment with even cash flow.
Fast Carriage Company is considering to purchase a large truck. The expected useful life of the truck is 14 years. The cost and net cash inflow associated with the new truck is as follows:
- Cost of new truck: $273,400
- Expected annual net cash inflow: $50,000
Required: Compute internal rate of return of the truck. Is the investment in truck desirable if management wants a 15% return on all such investments?
Step 1 – Computation of internal rate of return factor:
The first step is to compute the internal rate of return factor by dividing investment required to purchase truck by net annual cash inflows.
Internal rate of return factor = Investment required/Net annual cash inflow
Step 2 – Finding the internal rate of return promised by truck:
We would search for IRR factor (5.468) computed in step 1 in “present value of an annuity of $1 in arrears table“. In 14-period line, we can see that 5.468 factor represents a 16% rate of return. The internal rate of return of the truck is, therefore, 16%.
Step 3 – Comparing truck’s rate of return and management’s desired rate of return:
As the internal rate of return of the truck (16%) found in step 2 is greater than the management’s desired rate of return (15%), the investment in new truck is desirable.