Question

Suppose for an investment of 10,000 you will receive payments at the end of each of the next four years in the amounts 2000, 3000, 4000 and 3000. What is the rate of return per year? (Use Newton's Method)

Answer 1

Let us assume that the rate of return per year is r

10,000 = 2000/(1+r) + 3000/(1+r)^2 + 4000/(1+r)^3 + 3000/(1+r)^4

To calculate r we use the internal rate of return (IRR) method in excel as shown below. We use the IRR() function to calculate r.

Year	Cash flow
0	-10000
1	2000
2	3000
3	4000
4	3000
IRR	7.18%

Required rate of return = 7.18%

Alternatively, we can calculate r by trial and error method. We can plug in the value of r and then see if the left side equals the right side. This is a time consuming process and hence we use the IRR function in excel