Anderson International Limited is evaluating a project in Erewhon. The project w

Question

Anderson International Limited is evaluating a project in Erewhon. The project will create the following cash flows: Year Cash Flow All cash flows will occur in Erewhon and are expressed in dollars. In an attempt to improve its economy, the Erewhonian government has declared that all cash flows created by a foreign company are 'blocked' and must be reinvested with the government for one year. The reinvestment rate for these funds is 4 percent. If Anderson uses a required return of 9 percent on this project, what are the NPV and IRR of the project? (Negative amount should be indicated by a minus sign. Do not round intermediate calculations and round your final answers to 2 decimal places,

Explanation / Answer

As the cashflows are reinvested for one additional year at 4%, effectively Erehwon receives its year 1 cashflows in year 2, its year 2 cashflows in year 3 and so on. Please note - it does not receive any cashflow in year 1.

Amount received in year 2 = year 1 cashflow * (1+4%) = 375,000 * 1.04 = 390,000

Amount received in year 3 = year 2 cashflow * (1+4%) = 440,000 * 1.04 = 457,600

Amount received in year 4 = year 3 cashflow * (1+4%) = 335,000 * 1.04 = 348,400

Amount received in year 5 = year 4 cashflow * (1+4%) = 290,000 * 1.04 = 301,600

So NPV = -1,200,000 + 390,000/(1+9%)^2 + 457,600/(1+9%)^3 + 348,400/(1+9%)^4 + 301,600/(1+9%)^5 = -75,559

Let IRR be r%. NPV = 0 when discount rate is IRR.

So 0 = -1,200,000 + 390,000/(1+r)^2 + 457,600/(1+r)^3 + 348,400/(1+r)^4 + 301,600/(1+r)^5

Solving, we get r = IRR = 6.86%

Answer: NPV = -75,559 (i.e. negative 75,559)

IRR = 6.86%

Hope this helped ! Let me know in case of any queries.

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