Question

Park Co. is considering an investment that requires immediate payment of $28,245 and provides expected cash inflows of $9,300 annually for four years. Assume Park Co. requires a 7% return on its investments.

Required:
a. What is the internal rate of return?
b. Based on its internal rate of return, should Park Co. make the investment?

Answer 1

a) Internal rate of return (IRR) = 12.70 %

b) Park Co should make the return because the IRR is higher than the return on investment of 7%. This implies that undertaking the investment would increase the the wealth of the shareholders

Step-by-step explanation:

The IRR is the discount rate that equates the present value of cash inflows to that of cash outflows. At the IRR, the Net Present Value (NPV) of a project is equal to zero

If the IRR greater than the required rate of return , we accept the project for implementation

If the IRR is less than that the required rate , we reject the project for implementation

IRR = a% + ( NPVa/(NPVa + NPVb)× (b-a)%

NPV = PV of cash inflow - initial cost

PV of cash inflow = A× (1- (1+r)^(-n) )/r

A- cash inflow , r- rate of return, n- number of years

Step 1 :

NPVa at 7%

NPV = (9300 × (1- 1.07^(-4)/0.07 ) - 28,245 = 3,256.06

Step 2:

NPVb at 20%

NPV = (9300 × (1- 1.07^(-4)/0.07 ) - 28,245 = (4,169.77)

Step 3 :

IRR = a% + ( NPVa/(NPVa + NPVb)× (b-a)%

= 7% + (3,256.06 /(3,256.06 + 4,169.77)) × (20-7)%= 12.70

IRR = 12.70%

a) Internal rate of return (IRR) = 12.70 %

b) Park Co should make the return because the IRR (12.70%) is higher than the return on investment of 7%. This implies that undertaking the investment would increase the the wealth of the shareholders