Exercise-11: Internal rate of return (IRR) method with even cash inflow
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.
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