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Q: Investment Rules ( IRR and NPV) ( Answered,   0 Comments )
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 Subject: Investment Rules ( IRR and NPV) Category: Business and Money > Finance Asked by: bladehulk-ga List Price: \$20.00 Posted: 31 Oct 2006 09:16 PST Expires: 30 Nov 2006 09:16 PST Question ID: 778799
 ```Suppose you are offered \$5000 today but must make the following payments: year 0 5000 year 1 -2500 year 2 -2000 year 3 -1000 year 4 -1000 a. What is the IRR of this offer? b. If the appropriate discount rate is 10%, should you accept this offer? c. If the appropriate discount rate is 20%, should you accept this offer? d. What is the NPV of the offer if the appropriate discount rate is 10%? 20%? e. Are the decisions under the NPV rule in part (d) consistent with those of the IRR rule?```
 ```Hello! I've done the calculations you require in Excel, using the NPV and IRR functions. You can download this file from the following link: http://www.filefactory.com/file/b0b2a0/ Based on the information from this spreadsheet, we can now answer your questions. a. The IRR of this offer is 13.99% b. This question and the following one are a bit tricky. The usual decision rule when using IRR is: Discount Rate < IRR ----> Accept Project Discount Rate > IRR ----> Reject Project However, this decision rule only applies for the cases in which there is an initial cash outflow, and then several cash inflows across the next years. In this case, however, the stream of payments from the project in question is just the opposite. There is a cash inflow at the beginning, and then cash outflows during the next four years. Given that this is the case, then the decision rule for IRR must be REVERSED. We thus get that the appropiate decision rule for this case is: Discount Rate < IRR ----> Reject Project Discount Rate > IRR ----> Accept Project Therefore, since the discount rate (10%) is lower than the IRR, we conclude that the offer should be rejected. c. Using the "reversed" decision rule, we conclude that since the discount rate (20%) is higher than the IRR, the offer should be accepted. d. These are shown in the Excel file. The NPV when the discount rate is 10% is -\$359.95. When the discount rate is 20%, the NPV is \$466.82. e. The decision rule when using the NPV (this is irrespective of whether there is an initial cash outflow or inflow, as with the IRR) is that projects with positive NPV should be accepted, while projects with negative NPV should be rejected. Therefore, we conclude that: When Discount Rate = 10% --> NPV = -\$359.95 ---> REJECT OFFER When Discount Rate = 20% --> NPV = \$466.82 ---> ACCEPT OFFER As you can see, using NPV, we've arrived to the same decision we got when we used the appropiate decision rule with IRR. So the answer is yes, they are consistent. If you want additional information about the IRR, you might want to check the following links: Wikipedia - Internal Rate of Return http://en.wikipedia.org/wiki/Internal_rate_of_return Internal Rate of Return http://hspm.sph.sc.edu/COURSES/ECON/irr/irr.html Google search terms internal rate return ://www.google.com.ar/search?sourceid=navclient&ie=UTF-8&rls=GGLF,GGLF:2006-25,GGLF:en&q=internal+rate+return I hope this helps! If you have any doubt regarding my answer, please don't hesitate to request clarification before rating it. Otherwise, I await your rating and final comments. Best wishes! elmarto```