[cpaswag]

NINJA Question –

*Why are they multiplying 200,000 by 1.0? Where does this come from? And Becker said IRR is not calculation tested but I guess it is?

I’m having some trouble conceptualizing how to solve this problem. Can anyone provide a different explanation? Thanks for your help.

Allo Foundation, a tax-exempt organization, invested $200,000 in a 5-year project at the beginning of 2006. Allo estimates that the annual cash savings from this project will amount to $65,000. The $200,000 of assets will be depreciated over their 5-year life on the straight-line basis. On investments of this type, Allo’s desired rate of return is 12%. Information on present value factors is as follows:

AT 12% AT 14% AT 16%

Present value of 1 for 5 periods 0.5674 0.5194 0.4761

Present value of an annuity of

1 for 5 periods 3.6048 3.4331 3.2743

Allo’s internal rate of return on this project is:

Incorrect A.

less than 12%.

B.

less than 14%, but more than 12%.

C.

less than 16%, but more than 14%.

D.

more than 16%.

Solution:

PV of Cash Savings = PV of Investment Outlay

$65,000 x PV factor = $200,000 x 1.0

$65,000(PV factor) = $200,000

Then dividing by $65,000:

PV factor = $200,000 / $65,000

= 3.08

Referring to the present value factors in the question, the percentage rates for present value of an annuity indicates that a present value factor of 3.08 would relate to an interest rate of more than 16%.

[Hosmer]

I think that solution has some un-necessary junk in it.

The formula to start IRR is the same as the payback period. Same formula, different uses.

Formula for IRR and Payaback Period = Amount Borrowed / Expected Revenue per Year

In this case 3.08 = 200,000/65,000

You don't discount (take present values) for this ratio. No need to multiply either number by anything.

Now, to answer the question you need to take that 3.08 and compare it to the PV factors for an ordinary annuity (since it's 65,000 per year it's not PV of 1.).

Do you get it from there?

[Author]

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