Thompson Stores is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC (and even negative), in which case it will be rejected.
Year Cash Flow
0 ($1,000)
1 $300
2 $295
3 $290
4 $285
5 $270
14%
To find the project's internal rate of return (IRR), you need to calculate the discount rate at which the present value of the cash inflows equals the initial investment (the negative cash flow at Year 0).
Here's how you can calculate the IRR step-by-step:
1. List the cash flows:
Year 0: -1,000
Year 1: 300
Year 2: 295
Year 3: 290
Year 4: 285
Year 5: 270
2. Identify the formula for calculating the present value of cash flows (PV) for each year. The formula is:
PV = Cash Flow / (1 + r)^n
Where:
PV = Present Value of cash flows
Cash Flow = Cash Flow in each year
r = Discount rate (IRR in this case)
n = Year
3. Assume an initial IRR value (usually a guess).
4. Calculate the present value for each year according to the formula above using the guessed IRR.
Year 0: -1,000 / (1 + r)^0 = -1,000
Year 1: 300 / (1 + r)^1
Year 2: 295 / (1 + r)^2
Year 3: 290 / (1 + r)^3
Year 4: 285 / (1 + r)^4
Year 5: 270 / (1 + r)^5
5. Sum up the present values of all cash flows.
6. Adjust the guess for the IRR until the sum of the present values of the cash flows is equal to zero (or close to zero).
By guessing and adjusting the discount rate (IRR) until the sum of the present values of all cash flows is zero, you can determine the project's IRR. You can use a financial calculator or Microsoft Excel's IRR function to make this iterative calculation process easier.
Note: In this case, since the cash outflow (Year 0) is larger than the cash inflows, it's possible that the IRR could be negative or less than the Weighted Average Cost of Capital (WACC). In such a scenario, the project would be rejected.