Problem 40 in the 5th edition. TIMEVAL
37. Amitron Inc. is considering an engineering project that requires an investment of $250,000
and is expected to generate the following stream of payments (income) in the future. Use the
TIMEVAL program to determine if the project is a good idea in a present value sense. That is,
does the present value of expected cash inflows exceed the value of the investment that has to be
made today?
Year
Payment
1
$63,000
2
$69,500
3
$32,700
4
$79,750
5
$62,400
6
$38,250
a. Answer the question if the relevant interest rate for taking present values is 9%, 10%, 11%
and 12%. In the program, notice that period zero represents a cash flow made at the present time,
which isn't discounted. The program will do the entire calculation for if you input the initial
investment as a negative number in this cell.
b. Use trial and error in the program to find the interest rate (to the nearest hundredth of a
percent) at which Amitron would be just indifferent to the project.
This problem is a preview of an important method of evaluating projects known as capital
budgeting. We'll study the topic in detail in chapters 9, 10, and 11. In part a of this problem, we
found the net present value (NPV) of the project's cash flows at various interest rates, and
reasoned intuitively that the project was a good idea if that figure was positive. In part b we
found the return inherent in the project itself, which is called the internal rate of return (IRR).
We'll learn how to use that in Chapter 9.
SOLUTION: a.
k
NPV
9%
$11,405 good idea
10%
4,086 good idea
11%
(2,910) bad idea
12%
(9,601) bad idea
b. Indifference implies NPV = 0 which occurs at k = 10.58%
You can enter the cash flows in your calculator and find the IRR, which is the answer to b above.