What is the internal rate of return for Company L's new project?
The internal rate of return (IRR) is the interest rate that a firm must provide on investment so that the net present value (NPV) of cash inflows equals the net present value of cash outflows. In other words, it is the interest rate at which the NPV of a project is zero. When the NPV of a project is equal to zero, the firm is earning exactly its required rate of return for the investment. The formula to calculate the IRR is shown below:-
Net Present Value (NPV) = Cash flow/(1+internal rate)^t-Initial investment=0
Where, NPV is the net present value of cash inflows, and t is the time period of cash flow.
Years Cash Flow
1 €100,000
2 €100,000
3 €100,000
4 €200,000
5 €80,000
6 €70,000
We have to calculate the internal rate of return (IRR) for the project. Hence, the correct option is (d) 11%.
Explanation:
The internal rate of return (IRR) is a crucial metric in evaluating the feasibility of an investment project. It represents the rate of return at which the present value of cash inflows equals the present value of cash outflows. In simpler terms, IRR is the discount rate that makes the net present value (NPV) of a project zero.
In the case of Company L's new project, the initial investment is €400,000, and the cash flows for the next six years are as follows:
- Year 1: €100,000
- Year 2: €100,000
- Year 3: €100,000
- Year 4: €200,000
- Year 5: €80,000
- Year 6: €70,000
By using the formula for calculating IRR, the internal rate of return is determined to be 11%, making option (d) the correct answer.
In essence, the internal rate of return serves as a benchmark for determining the profitability and attractiveness of an investment opportunity. It helps businesses make informed decisions regarding capital allocation and project selection based on the expected returns and risk factors involved. A higher IRR indicates a more lucrative investment, while a lower IRR may signal potential risks or inefficiencies in the project.
Therefore, understanding and calculating the internal rate of return is essential for companies like Company L to optimize their investment strategies and achieve sustainable growth in the long run.