Question

Modern Federal Bank is setting up a brand-new branch. The cost of the project will be $1.2 million. The branch will create additional cash flows of $235,000, $412,300, $665,000 and $875,000 over the next four years. The firm's cost of capital is 12 percent. What is the internal rate of return on this branch expansion? (Do not round intermediate computations. Round final answer to the nearest percent.)

Answer 1

Answer:

The internal rate of return on this branch expansion is 23%

Explanation:

The internal rate of return (IRR) is the rate which then net present value of project is zero.

We can use excel to easily generate the IRR of a project with cash flows in and out.

The internal rate of return on this branch expansion = IRR(-$1.2 million, $235,000, $412,300, $665,000,$875,000) = 23%

Answer 2

Answer:

Year   Cashflow    DF@12%      PV           DF@25%     PV

               $                                 $                                  $

  0        (1,200,000)       1           (1,200,000)        1          (1,200,000)

  1           235,000        0.8929   209.831.50   0.8          188,000

  2           412,300        0.7972    328.685.56   0.64       263,872

  3            665,000      0.7118      473,347.00    0.512      340,480

  4            875,000       0.6355    556,062.50  0.4096   358,400

                                             NPv   367,926.56       NPV   (49,248)

IRR = LR     + NPV1/NPV1+NPV2    x (HR – LR)

IRR = 12       + 367,926.56/367,926.56 + 49,248   x (25– 10)

IRR = 12       + 367,926.56/417,174.56 x 15

IRR =  12         + 13.23

IRR = 25%

 

Explanation:

In determining internal rate of return, the project will be discounted at 12% for 4 years in order to obtain the positive NPV. Then, we will increase the discount rate arbitrarily so as to obtain the negative NPV. Finally, we will apply interpolation formula to determine the internal rate of return.