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Answer Question Consider an investment that costs $100,000 and has a cash inflow of $25,000 every year for 5 years
Answer Question
Consider an investment that costs $100,000 and has
a cash inflow of $25,000 every year for 5 years. The
required return is 9% and required payback is 4
years.
• What is the payback period?
• What is the NPV?
• What is the IRR?
• Should we accept the project?
• What decision rule should be the primary decision
method?
• When is the IRR rule unreliable?
Expert Solution
1.Computation of Payback Period:
Payback Period = Initial Investment / Annual Cash Flow
= $100,000/$25,000
Payback Period = 4 years
The NPV is -$2,758.72 (Negative) showing the project is not profitable.
The IRR of the project is 7.93% which is less than the required return of 9%. Hence the project should be rejected.
4. Since the project is having a negative NPV and an IRR lower than required return, the should not be accepted.
5. The Net Present Value (NPV) is the primary decision maker.
6. IRR rule is unreliable when projects have unconventional cash flows (positive and negative cash flows in the following years)
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