Question

2. OpenSeas, Inc. is evaluating the purchase of a new cruise ship. The ship would cost $500 million, and would operate for 20 years. Open Seas expects annual cash flows from operating the ship to be $70 million (at the end of each year) and its cost of capital is 12%. a) What is the NPV of the purchase? b) What is the IRR of the purchase?

Answer 1

Initial Cost = 500 million

Annual Cash flow (Inflows) = 70 million

Life = 20 years

Cost of Capital (interest rate) = 12%

a. What is the NPV?

NPV = -500 million + 70 million (P/A, 12%, 20)

NPV = -500 million + 70 million (7.46944) = 22.86 million

The NPV of the purchase is 22.86 million

b. What is the IRR?

Calculate the IRR using the trial and error method.

At 12% the calculated NPV = 22.86 million

The NPV is positive. So increase the rate of interest to get a negative NPV. Increase the rate of interest to 13% and calculate NPV.

NPV = -500 million + 70 million (P/A, 13%, 20)

NPV = -500 million + 70 million (7.02475) = -8.27 million

Using interpolation,

IRR = 12% + [22.86 million – 0 ÷ 22.86 million – (-8.27 million)] * 1

IRR = 12.73%

The IRR is 12.73%