Chapter 7 Internal Rate of Return

7-1 Tony invested $15,000 in a high yield account. At the end of 30 years he closed the account and received $539,250. Compute the effective interest rate he received on the account. Solution Recall that F = P(1 + i) n 539,250 = 15,000(1 + i)30 ! 539,250/15,000 = (1 + i)30 35.95 = (1 + i)30 30 35.95 " 1 # i 11268 . "1# i . 1268 " i i " 12.68%

7-2 The heat loss through the exterior walls of a processing plant is estimated to cost the owner $3,000 next year. A salesman from Superfiber, Inc. claims he can reduce the heat loss by 80 % with the installation of $ 15,000 of Superfiber now. If the cost of heat loss rises by $200 per year, after next year (gradient), and the owner plans to keep the building ten more years, what is his rate of return, neglecting depreciation and taxes? Solution NPW = 0 at the rate of return Try 12% NPW = -15,000 + .8(3,000)(P/A, 12%, 10) + .8(200)(P/G, 12%, 10) = $1,800.64 Try 15% NPW = -$237.76 By interpolation i = 14.7%

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7-3 Does the following project have a positive or negative rate of return? Show how this is known to be true. Investment cost Net benefits Salvage Useful life Solution Year 1 2 3 4 5 Benefits 300 500 700 900 50 Total = 2,450 < Cost $2,500 $300 in Year 1, increasing by $200/year $50 4 years

Total Benefits obtained are less than the investment, so the "return" on the investment is negative

7-4 At what interest rate would $1000 at the end of 1995 be equivalent to $2000 at the end of 2002? Solution (1 + i)7 = 2 ; i = (2)1/7 - 1 = 0.1041 or 10.41%

7-5 A painting, purchased one month ago for $1000, has just been sold for $1700. What nominal annual rate of return did the owner receive on his investment? Solution i = 7,000/1,000 = 70% IRR = 70 x 12 = 840%

7-8 Find the rate of return for a $10,000 investment that will pay $1000/year for 20 years. Solution 10,000 = 1,000(P/A, i%, 20) (P/A, i%, 20) = 10 From tables: 7% < i < 8% $ interpolate i = 7.77%

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7-9 A young engineer has a mortgage loan at a 15% interest rate, which he got some time ago, for a total of $52,000. He has to pay 120 more monthly payments of $620.72 each. As interest rates are going down, he inquires about the conditions under which he could refinance the loan. If the bank charges a new loan fee of 4% of the amount to be financed, and if the bank and the engineer agree on paying this fee by borrowing the additional 4% under the same terms as the new loan, what percentage rate would make the new loan attractive, if the conditions require him to repay it in the same 120 payments? Solution The amount to be refinanced: a) PW of 120 monthly payments left P = A(P/A, i, n) = 620.72(P/A, 15%/12, 120) = $38,474.09

b) New loan fee (4 %) 38,474.09 x 0.04 = $1,538.96 ! Total amount to refinance = 38,474.09 + 1,538.96 = 40,013.05 The new monthly payments are: ANEW = 40,013.05 (A/P, i, 120) The current payments are: AOLD = 620.72 We want ANEW < AOLD Substituting ! 40,013.05(A/P, i, 120) < 620.72 (A/P, i, 120) < 620.72/40,013.05 = 0.0155 for i = 1% for i = 1% (A/P, 1%, 120) = 0.0143 (A/P, 1%, 120) = 0.0161

1% < i < 1% $ interpolate i = 1.1667 % This corresponds to a nominal annual percentage rate of 12 x 0.011667 = 14 % Therefore, she has to wait until interest rates are less than 14%.

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7-10 Your company has been presented with an opportunity to invest in a project. The facts on the project are presented below: Investment required $60,000,000 Annual Gross income 20,000,000 Annual Operating costs: Labor 2,500,000 Materials, licenses, insurance, etc. 1,000,000 Fuel and other costs 1,500,000 Maintenance costs 500,000 Salvage value after 10 years 0 The project is expected to operate as shown for ten years. If your management expects to make 25% on its investments before taxes, would you recommend this project? Solution Net income = 20M (2.5M + 1M + 1.5M + .5M) = $14,500,000 NPW = 0 at the rate of return 0 = - 60,000,000 + 14,500,000(P/A, i, 10) (P/A, i, 10) = 60/14.5 = 4.138 @20% @25% P/A = 4.192 P/A = 3.571

20% < i < 25% $ interpolate i = 20.43% IRR < 25 % $ Reject Project

7-11 Consider the following investment in a piece of land. Purchase price $10,000 Annual maintenance: 100 Expected sale price after 5 years: $20,000 Determine: (a) A trial value for i (b) The rate of return ( to 1/100 percent) (c) What is the lowest sale price the investor should accept if she wishes to earn a return of 10% after keeping the land for 10 years?

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7-12 Calculate the rate of return of the following cash flow with accuracy to the nearest 1/10 percent. A = $1,000

$3,100 Solution NPW = 0 at the rate of return 0 = -3,100 + 1,000(P/A, i, 5) (P/A, i, 5) = 3.1 (P/A, 20%, 5) = 2.991 (P/A, 18%, 5) = 3.127 18% < i < 20% $ interpolate i = 18.4%

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7-13 An investment that cost $1000 is sold five years later for $1261. What is the nominal rate of return on the investment (interest rate)? Solution F = P (F/P, i %, 5) 1,261 = 1,000 (F/P, i %, 5) (F/P, i %, 5) = 1,261/1,000 = 1.2610 From tables: (F/P, 4%, 5) = 1.246 (F/P, 5%, 5) = 1.276 4% < i < 5% $ interpolate i = 4.75%

7-14 Elizabeth made an initial investment of $5000 in a trading account with a stock brokerage house. After a period of 17 months the value of the account had increased to $8400. What is the nominal annual interest rate realized on the initial investment if it is assumed there were no additions or withdrawals from the account? Solution F = P(F/P, i, 17) F/P = 8,400/5,000 = 1.68 (1 + i)17 = 1.68 1 + i = (1.68)1/17 = 1.031 Annual interest rate = 3.1 x 12 = 37.2%

7-15 You borrowed $25 from a friend and after five months repaid $27. What interest rate did you pay (annual basis)?

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7-16 You have a choice of $3,000 now, or $250 now with $150 a month for two years. What interest rate will make these choices comparable? Solution 3,000 = 250 + 150 (P/A, i, 24) P/A = 18.33 @ 2% @ 2% P/A = 18.914 P/A = 17.885

2% < i < 2% $ interpolate i = = 2.28% or 27.36% per year

7-17 Sain and Lewis Investment Management Inc., is considering the purchase of a number of bonds to be issued by Southeast Airlines. The bonds have a face value of $10,000 and a face rate of 7.5% payable annually. The bonds will mature ten years after they are issued. The issue price is expected to be $8,750. Determine the yield to maturity (IRR) for the bonds. If SLIM Inc. requires at least a 10% return on all investments should they invest in the bonds? Solution

Year 0 1-10 10

First Cost Interest 750(P/A, i%, 10) Maturity 10,000(P/F, i% n) NPW =

10% -8,750.00 +4,608.75 +3,855.00 -$286.25

12% -8,750.00 +4,813.50 +4,224.00 $287.50

10% < IRR < 12% $ interpolate i = 9.5% ! Do not invest.

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7-18 A 9.25% coupon bond issued by Gurley Gears LLC is purchased January 1, 2002 and matures December 31, 2010. The purchase price is $1079 and interest is paid semi-annually. If the face value of the bond is $1,000, determine the effective internal rate of return. Solution n = 9 x 2 = 18 year periods Year 0 1-18 18 IRR = (1 + .04)2 1 = 8.16% 4% -1,079.00 +585.48 +493.60 $.08

First Cost Interest 46.25(P/A, i%, 18) Maturity 1000(P/F, i%, 18) NPW =

7-19 Joes Billiards Inc. stock can be purchased for $14.26 per share. If dividends are paid each quarter at a rate of $0.16 per share, determine the effective i if after 4 years the stock is sold for $21.36 per share. Year 0 1-16 16 3% -14.26 +2.01 +13.31 $1.06 3 -14.26 +1.93 +12.32 -$.01

Cost Dividends .16(P/A, i%, 16) Sale 21.36(P/F, i%, 16) NPW =

i = 3 per quarter effective i = (1 + .035)4 1 = 14.75%

7-20 A bond with a face value of $1,500 can be purchased for $800. The bond will mature five years from now and the bond dividend rate is 12%. If dividends are paid every three months, what effective interest rate would an investor receive if she purchases the bond?

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A = $45

$1,500 + $45

NPW = 0 at IRR 0 = -800 + 45(P/A, i%, 20) + 1,500(P/F, i%, 20) By trial and error: Try 7% Try 8% NPW = +$64.33 NPW = -$36.44

7% < i < 8% $ interpolate i = 7.64 % Effective interest rate = (1+ i) -1 = (1+0.07638) - 1 = 0.3423 = 34.23%
m 4

7-21 How many positive rates of return does the following cash flow have? Year 0 1 2 3 4 5 6 7 Cash Flow -$50,000 +25,000 +25,000 0 -50,000 +25,000 +25,000 +25,000

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Solution

Chapter 7 Internal Rate of Return

Year 0 1 2 3 4 5 6 7

Accumulated Cash Flow -$50,000 -25,000 0 0 -50,000 -25,000 0 +25,000=A 7

3 sign changes in cash flow Cash Flow Rule of Signs: There may be as many as 3 positive ROR Accumulated Cash Flow: A 7 % 0, one sign change in accumulated cash flow, $one positive rate of return

Note: also check to see if there is any external investments during project life.