Consider an asset with the following cash flows:
Year | ||||
| 0 | 1 | 2 | 3 |
Cash flows ($ millions) | −12 | +5.20 | +4.80 | +4.40 |
The firm uses straight-line depreciation. Thus, for this project, it writes off $4 million per year in years 1, 2, and 3. The discount rate is 10%.
a. Show that economic depreciation equals book depreciation.
b. Show that the book rate of return is the same in each year.
c. Show that the project’s book profitability is its true profitability.
You’ve just illustrated another interesting theorem. If the book rate of return is the same in each year of a project’s life, the book rate of return equals the IRR.
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