Question

Anderson International Limited is evaluating a project in Erewhon. The project will create the following cash flows:

Year Cash Flow
0 –$ 1,275,000
1 435,000
2 505,000
3 415,000
4 345,000
All cash flows will occur in Erewhon and are expressed in dollars. In an attempt to improve its economy, the Erewhonian government has declared that all cash flows created by a foreign company are "blocked" and must be reinvested with the government for one year. The reinvestment rate for these funds is 4 percent.

If Anderson uses a required return of 11 percent on this project, what are the NPV and IRR of the project?

Answer 1

To calculate NPV and IRR, the future cash flows are reinvested at 4% due to government policies, then discounted back at 11%. NPV will include this adjusted reinvestment and IRR is the rate that sets NPV to zero when considering these cash flows.

Step-by-step explanation:

To determine the Net Present Value (NPV) and Internal Rate of Return (IRR) of Anderson International Limited's project, the cash flows must be adjusted for the 4 percent reinvestment rate mandated by the Erewhonian government and then discounted at the required return rate of 11 percent.

The cash flows from Years 1 to 3 will each be reinvested for one year at a rate of 4 percent, resulting in revised cash flows:

• Year 1: $435,000 × (1 + 0.04) = $452,400
• Year 2: $505,000 × (1 + 0.04) = $525,200
• Year 3: $415,000 × (1 + 0.04) = $431,600

The NPV calculation is as follows (not including the initial investment of -1,275,000 for simplification):

• NPV = ($452,400 / (1 + 0.11)1) + ($525,200 / (1 + 0.11)2) + ($431,600 / (1 + 0.11)3) + ($345,000 / (1 + 0.11)4)

The IRR can be found using financial calculator or software by inputting these cash flows and solving for the rate where NPV = 0.

These results will establish whether the project meets the company's financial expectations when considering the cost of capital and reinvestment stipulation.