Question

2. Imagine you start your own ice cream company, and the cashflows for the first 5 years are given as follows: Initial Investment (Co) $100,000 Year 1 -$25,000 Year 2 -$5,000 Year 3 $50,000 Year 4 $150,000 Using 15% for discounting, what is the net present value (NPV) of this investment? Find the internal rate of return (IRR). Do you make the investment? Why? If you suddenly decide that you want a 10% return your first 4 years in business, do you make the initial investment?

Answer 1

Answer-

Initial investment	$ 100000
Year 1	- $ 25000
Year 2	- $ 5000
Year 3	$ 50000
Year 4	$ 150000

Discount rate = 15 %

NPV = - $ 100000 - $ 25000 /1.15 - $ 5000 / 1.15² + $ 50000 / 1.15³ + $ 150000 / 1.15⁴
NPV = - $ 100000 - $ 25000 / 1.15 - $ 5000 / 1.3225 + $ 50000 / 1.521 + $ 150000 / 1.749
NPV = - $100000 - $ 21739.13 - $ 3780.72 + $ 32873.12 + $ 85763.29
NPV = - $ 125519.85 + $ 118636.41
NPV = - $ 6883.44

IRR = 13.16 %

The investment should not be made as the project has negative NPV ( - $ 6883.44) even though it has an IRR of 13.16 %. The NPV should be given preference over IRR.

The required first four of investment is

initial Investment	$ 100000
Year 1	- $ 25000
Year 2	- $ 5000
Year 3	$ 50000

There are three negative cash flows of - $ 100000 in year 0, - $ 25000 in year 2, - $ 5000 in year 3 followed by only positive cash flow of $ 50000. Therefore
NPV will be negative and
IRR = - 30 %  

Therefore the initial investment should not be made if one needs a return of 10 % in first four years,

Finally it's not worth investing in this project as it is giving an overall negative NPV and preference should be given to NPV even though there is a positive IRR of 13.16 % for complete project