Internal Rate of Return (IRR)

FM – May 2024 – L3 – SB – Q2 – Investment Appraisal Techniques

Evaluate a proposed investment for Keke Plc, identify errors in the initial appraisal, recalculate NPV, and discuss IRR and business risk issues.

Question

The following draft appraisal of a proposed investment project has been prepared for the Finance Director of Keke Plc (KP) by a trainee accountant. The project is consistent with the current business operations of KP.

Year	1	2	3	4	5
Sales (units/yr)	250,000	400,000	500,000	250,000
Contribution (₦000)	13,300	21,280	26,600	13,300	–
Fixed costs (₦000)	(5,300)	(5,618)	(5,955)	(6,312)	–
Depreciation (₦000)	(4,375)	(4,375)	(4,375)	(4,375)	–
Interest payments (₦000)	(2,000)	(2,000)	(2,000)	(2,000)	–
Taxable profit (₦000)	1,625	9,287	14,270	613
Taxation (₦000)	–	(488)	(2,786)	(4,281)	(184)
Profit after tax (₦000)	1,625	8,799	11,484	(3,668)	(184)
Scrap value (₦000)	–	–	–	2,500	–
After-tax cash flows (₦000)	1,625	8,799	11,484	(1,168)	(184)
Discount at 10%	0.909	0.826	0.751	0.683	0.621
Present values (₦000)	1,477	7,268	8,624	(798)	(114)

Net present value = (16,457,000 – 20,000,000) = ₦3,543,000, so reject the project.

Additional Information:

The initial investment is ₦20 million.
Selling price: ₦120/unit (current price terms), selling price inflation is 5% per year.
Variable cost: ₦70/unit (current price terms), variable cost inflation is 4% per year.
Fixed overhead costs: ₦5,000,000/year (current price terms), fixed cost inflation is 6% per year.
₦2,000,000/year of the fixed costs are development costs that have already been incurred and are being recovered by annual charges to the project.
Investment financing is by a ₦20 million loan at a fixed interest rate of 10% per year.
Keke Plc can claim 25% reducing balance tax allowable depreciation on this investment and pays taxation one year in arrears at a rate of 30% per year.
The scrap value of machinery at the end of the four-year project is ₦2,500,000.
The real weighted average cost of capital of Keke is 7% per year.
The general rate of inflation is expected to be 4.7% per year.

Required:

a. Identify and comment on any errors in the investment appraisal prepared by the trainee accountant.
(4 Marks)

b. Prepare a revised calculation of the net present value of the proposed investment project and comment on the project’s acceptability.
(12 Marks)

c. Discuss the problems faced when undertaking investment appraisal in the following areas and comment on how these problems can be overcome:
i. An investment project has several internal rates of return;
ii. The business risk of an investment project is significantly different from the business risk of current operations.
(4 Marks)

(Total: 20 Marks)

Answer

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Tags: Business risk, Depreciation, Discount rate, Fixed Costs, Inflation, Internal Rate of Return (IRR), Investment Appraisal, Net Present Value (NPV)
Level: Level 3

Topic: Investment Appraisal Techniques
Series: MAY 2024

BMF – Nov 2020 – L1 – SB – Q5 – Investment Decisions

Evaluate the investment project using IRR and advise management on the project feasibility.

Question

Uhuru Nigeria Limited wants to buy a new item of equipment which will be used to improve service delivery to its customers. Using the internal rate of return (IRR) method of investment appraisal, you are required to evaluate the project and advise the management of the company. Estimated cash flows from the project are as provided below:

Year	Cash Flow (N)
0	(400,000)
1	140,000
2	150,000
3	170,000
4	190,000

The expected minimum required rate of return of the company is fixed at 25%.

Answer

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Tags: Capital Budgeting, Cash Flow Analysis, Internal Rate of Return (IRR), Investment Appraisal, Rate of Return
Level: Level 1

Topic: Investment Decisions
Series: NOV 2020

AFM – May 2018 – L3 – Q2 – Discounted cash flow techniques | Valuation and the use of free cash flows

Evaluating investment options using NPV and IRR to advise a company on which projects should be undertaken.

Question

The Board of Peartek Ltd is considering the company’s capital investment options for the coming year, and is evaluating the following potential investments:

Investment A:

Investment of GH¢60,000, including GH¢40,000 for capital equipment and GH¢20,000 for increases in working capital.
Expected sales of 10,000 units next year with a sales price of GH¢10 and variable costs of GH¢6 per unit.
Sales price is expected to decline by 20% per annum due to competition, sales volume to fall by 10%, and variable costs to decline by 20%.
Overheads of GH¢15,000 annually, including a GH¢4,000 depreciation charge.
The project will be wound up in year three, with working capital recovered and capital equipment sold off for 25% of its cost.

Investment B:

Immediate outlay of GH¢90,000, financed by borrowing at 6%.
Expected net profits of GH¢12,000 next year, rising by 3% per annum indefinitely.

Investment C:

Outlay of GH¢25,000 financed by retained profits.
Expected annual net cash profits:
- Years 1 to 4: GH¢3,000
- Years 5 to 7: GH¢5,000
- From year 8 onwards: GH¢7,000 in perpetuity.

The company discounts projects lasting 10 years or less at 10%, and others at 13%. Ignore taxation.

Required:

a) As a financial management analyst, you have been asked to advise the board of Peartek Ltd (in the form of a briefing report) which investment should be undertaken. Use the NPV method in your analysis. (15 marks)

b) Minority of board members feel that the Internal Rate of Return (IRR) should also be used as either an alternative or a complementary method of investment appraisal. Calculate the IRR of investments A and B and comment accordingly. (5 marks)

Answer

Find Related Questions by Tags, levels, etc.

Tags: Capital Budgeting, Internal Rate of Return (IRR), Investment Appraisal, Net Present Value (NPV)
Level: Level 3

Topic: Discounted cash flow techniques, Valuation and use of free cash flows
Series: MAY 2018

FM – NOV 2016 – L2 – Q3 – Cost of capital | Introduction to Investment Appraisal

Evaluates the viability of an investment using NPV and IRR and explains the criteria venture capitalists consider when funding applications.

Question

a) Sakyiama Poultry Farms is considering purchasing a new incubator that will improve its incubation efficiency to 90% as against the current 50%. The incubator, which is to be purchased immediately, will cost GH¢120,000. The incubator has a useful life of 4 years, after which it would be sold for scrap at GH¢10,000. The current contribution of GH¢3 per day-old chick will not change. The number of day-old chicks sold at 12,000 units per annum will increase by 80%. Fixed cost will be GH¢20,000 per annum. Sakyiama Farms has an after-tax cost of capital of 12.5% and pays tax in the year in which profit is made at a rate of 15% per annum. The farm is also entitled to capital allowance at 25% on a reducing balance.

i) Calculate the Net Present Value (NPV) and the viability of the investment. (7 marks)
ii) Calculate the Internal Rate of Return (IRR). (8 marks)

b) Two blue-chip companies – Abu Ltd and Ada Ltd are seeking to raise funds from venture capital to boost their production in order to satisfy demand for their solar-powered refrigeration and air-conditioning systems, which they developed through a joint venture. They have consulted you for advice.

Required:
Explain FIVE conditions that a venture capitalist will consider in accessing an application for funding. (5 marks)

Answer

Find Related Questions by Tags, levels, etc.

Tags: Capital Allowance, Internal Rate of Return (IRR), Investment Decision, Net Present Value (NPV), Venture Capital
Level: Level 2

Topic: Cost of capital, Introduction to Investment Appraisal
Series: NOV 2016

FM – May 2024 – L3 – SB – Q2 – Investment Appraisal Techniques

Evaluate a proposed investment for Keke Plc, identify errors in the initial appraisal, recalculate NPV, and discuss IRR and business risk issues.

Question

Year	1	2	3	4	5
Sales (units/yr)	250,000	400,000	500,000	250,000
Contribution (₦000)	13,300	21,280	26,600	13,300	–
Fixed costs (₦000)	(5,300)	(5,618)	(5,955)	(6,312)	–
Depreciation (₦000)	(4,375)	(4,375)	(4,375)	(4,375)	–
Interest payments (₦000)	(2,000)	(2,000)	(2,000)	(2,000)	–
Taxable profit (₦000)	1,625	9,287	14,270	613
Taxation (₦000)	–	(488)	(2,786)	(4,281)	(184)
Profit after tax (₦000)	1,625	8,799	11,484	(3,668)	(184)
Scrap value (₦000)	–	–	–	2,500	–
After-tax cash flows (₦000)	1,625	8,799	11,484	(1,168)	(184)
Discount at 10%	0.909	0.826	0.751	0.683	0.621
Present values (₦000)	1,477	7,268	8,624	(798)	(114)

Net present value = (16,457,000 – 20,000,000) = ₦3,543,000, so reject the project.

Additional Information:

The initial investment is ₦20 million.
Selling price: ₦120/unit (current price terms), selling price inflation is 5% per year.
Variable cost: ₦70/unit (current price terms), variable cost inflation is 4% per year.
Fixed overhead costs: ₦5,000,000/year (current price terms), fixed cost inflation is 6% per year.
₦2,000,000/year of the fixed costs are development costs that have already been incurred and are being recovered by annual charges to the project.
Investment financing is by a ₦20 million loan at a fixed interest rate of 10% per year.
Keke Plc can claim 25% reducing balance tax allowable depreciation on this investment and pays taxation one year in arrears at a rate of 30% per year.
The scrap value of machinery at the end of the four-year project is ₦2,500,000.
The real weighted average cost of capital of Keke is 7% per year.
The general rate of inflation is expected to be 4.7% per year.

Required:

a. Identify and comment on any errors in the investment appraisal prepared by the trainee accountant.
(4 Marks)

b. Prepare a revised calculation of the net present value of the proposed investment project and comment on the project’s acceptability.
(12 Marks)

(Total: 20 Marks)

Answer

Find Related Questions by Tags, levels, etc.

Tags: Business risk, Depreciation, Discount rate, Fixed Costs, Inflation, Internal Rate of Return (IRR), Investment Appraisal, Net Present Value (NPV)
Level: Level 3

Topic: Investment Appraisal Techniques
Series: MAY 2024

BMF – Nov 2020 – L1 – SB – Q5 – Investment Decisions

Evaluate the investment project using IRR and advise management on the project feasibility.

Question

Year	Cash Flow (N)
0	(400,000)
1	140,000
2	150,000
3	170,000
4	190,000

The expected minimum required rate of return of the company is fixed at 25%.

Answer

Find Related Questions by Tags, levels, etc.

Tags: Capital Budgeting, Cash Flow Analysis, Internal Rate of Return (IRR), Investment Appraisal, Rate of Return
Level: Level 1

Topic: Investment Decisions
Series: NOV 2020

AFM – May 2018 – L3 – Q2 – Discounted cash flow techniques | Valuation and the use of free cash flows

Evaluating investment options using NPV and IRR to advise a company on which projects should be undertaken.

Question

The Board of Peartek Ltd is considering the company’s capital investment options for the coming year, and is evaluating the following potential investments:

Investment A:

Investment of GH¢60,000, including GH¢40,000 for capital equipment and GH¢20,000 for increases in working capital.
Expected sales of 10,000 units next year with a sales price of GH¢10 and variable costs of GH¢6 per unit.
Sales price is expected to decline by 20% per annum due to competition, sales volume to fall by 10%, and variable costs to decline by 20%.
Overheads of GH¢15,000 annually, including a GH¢4,000 depreciation charge.
The project will be wound up in year three, with working capital recovered and capital equipment sold off for 25% of its cost.

Investment B:

Immediate outlay of GH¢90,000, financed by borrowing at 6%.
Expected net profits of GH¢12,000 next year, rising by 3% per annum indefinitely.

Investment C:

Outlay of GH¢25,000 financed by retained profits.
Expected annual net cash profits:
- Years 1 to 4: GH¢3,000
- Years 5 to 7: GH¢5,000
- From year 8 onwards: GH¢7,000 in perpetuity.

The company discounts projects lasting 10 years or less at 10%, and others at 13%. Ignore taxation.

Required:

Answer

Find Related Questions by Tags, levels, etc.

Tags: Capital Budgeting, Internal Rate of Return (IRR), Investment Appraisal, Net Present Value (NPV)
Level: Level 3

Topic: Discounted cash flow techniques, Valuation and use of free cash flows
Series: MAY 2018

FM – NOV 2016 – L2 – Q3 – Cost of capital | Introduction to Investment Appraisal

Evaluates the viability of an investment using NPV and IRR and explains the criteria venture capitalists consider when funding applications.

Question

i) Calculate the Net Present Value (NPV) and the viability of the investment. (7 marks)
ii) Calculate the Internal Rate of Return (IRR). (8 marks)

Required:
Explain FIVE conditions that a venture capitalist will consider in accessing an application for funding. (5 marks)

Answer

Find Related Questions by Tags, levels, etc.

Tags: Capital Allowance, Internal Rate of Return (IRR), Investment Decision, Net Present Value (NPV), Venture Capital
Level: Level 2

Topic: Cost of capital, Introduction to Investment Appraisal
Series: NOV 2016

Question Tag: Internal Rate of Return (IRR)

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FM – May 2024 – L3 – SB – Q2 – Investment Appraisal Techniques

Evaluate a proposed investment for Keke Plc, identify errors in the initial appraisal, recalculate NPV, and discuss IRR and business risk issues.

BMF – Nov 2020 – L1 – SB – Q5 – Investment Decisions

Evaluate the investment project using IRR and advise management on the project feasibility.

AFM – May 2018 – L3 – Q2 – Discounted cash flow techniques | Valuation and the use of free cash flows

Evaluating investment options using NPV and IRR to advise a company on which projects should be undertaken.

Investment A:

Investment B:

Investment C:

FM – NOV 2016 – L2 – Q3 – Cost of capital | Introduction to Investment Appraisal

Evaluates the viability of an investment using NPV and IRR and explains the criteria venture capitalists consider when funding applications.

FM – May 2024 – L3 – SB – Q2 – Investment Appraisal Techniques

Evaluate a proposed investment for Keke Plc, identify errors in the initial appraisal, recalculate NPV, and discuss IRR and business risk issues.

BMF – Nov 2020 – L1 – SB – Q5 – Investment Decisions

Evaluate the investment project using IRR and advise management on the project feasibility.

AFM – May 2018 – L3 – Q2 – Discounted cash flow techniques | Valuation and the use of free cash flows

Evaluating investment options using NPV and IRR to advise a company on which projects should be undertaken.

Investment A:

Investment B:

Investment C:

FM – NOV 2016 – L2 – Q3 – Cost of capital | Introduction to Investment Appraisal

Evaluates the viability of an investment using NPV and IRR and explains the criteria venture capitalists consider when funding applications.

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Question Tag: Internal Rate of Return (IRR)

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FM – May 2024 – L3 – SB – Q2 – Investment Appraisal Techniques

Evaluate a proposed investment for Keke Plc, identify errors in the initial appraisal, recalculate NPV, and discuss IRR and business risk issues.

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BMF – Nov 2020 – L1 – SB – Q5 – Investment Decisions

Evaluate the investment project using IRR and advise management on the project feasibility.

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AFM – May 2018 – L3 – Q2 – Discounted cash flow techniques | Valuation and the use of free cash flows

Evaluating investment options using NPV and IRR to advise a company on which projects should be undertaken.

Investment A:

Investment B:

Investment C:

You're reporting an error for "AFM – May 2018 – L3 – Q2 – Discounted cash flow techniques | Valuation and the use of free cash flows"

FM – NOV 2016 – L2 – Q3 – Cost of capital | Introduction to Investment Appraisal

Evaluates the viability of an investment using NPV and IRR and explains the criteria venture capitalists consider when funding applications.

You're reporting an error for "FM – NOV 2016 – L2 – Q3 – Cost of capital | Introduction to Investment Appraisal"

FM – May 2024 – L3 – SB – Q2 – Investment Appraisal Techniques

Evaluate a proposed investment for Keke Plc, identify errors in the initial appraisal, recalculate NPV, and discuss IRR and business risk issues.

You're reporting an error for "FM – May 2024 – L3 – SB – Q2 – Investment Appraisal Techniques"

BMF – Nov 2020 – L1 – SB – Q5 – Investment Decisions

Evaluate the investment project using IRR and advise management on the project feasibility.

You're reporting an error for "BMF – Nov 2020 – L1 – SB – Q5 – Investment Decisions"

AFM – May 2018 – L3 – Q2 – Discounted cash flow techniques | Valuation and the use of free cash flows

Evaluating investment options using NPV and IRR to advise a company on which projects should be undertaken.

Investment A:

Investment B:

Investment C:

You're reporting an error for "AFM – May 2018 – L3 – Q2 – Discounted cash flow techniques | Valuation and the use of free cash flows"

FM – NOV 2016 – L2 – Q3 – Cost of capital | Introduction to Investment Appraisal

Evaluates the viability of an investment using NPV and IRR and explains the criteria venture capitalists consider when funding applications.

You're reporting an error for "FM – NOV 2016 – L2 – Q3 – Cost of capital | Introduction to Investment Appraisal"

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