Trial and error method, Finance Basics

Trial and Error Method

a) Select any rate of interest on random and employ it to compute NPV of cash inflows.

b) If rate selected produces NPV lower than the cost, want a lower rate.

c) If the rate selected in (a) above provides NPV greater than the cost, select a higher rate.  Continue the process till the NPV is equal to zero and such will be the IRR.

Example

A project costs 16,200/= and is expected to generate the following inflows:

                            Shs.

Year 1                  8,000

Year 2                  7,000

Year 3                  6,000

Calculate the IRR of this type of venture.

Solution

1st choice 10 percent

8,000 - (1.1)1 + 7,000 - (1.1)2 + 6,000 - (1.1)3 =  17,565.74 > cost, choose a higher rate.

2nd choice 14 percent

8,000 - (1.14)1 + 7,000 - (1.14)2 + 6,000 - (1.14)3 =    16,453.646

3rd choice 15 percent

8,000 - (1.15)1 + 7,000 - (1.15)2 + 6,000 - (1.15)3 =    16,194.625

IRR lies between 14 percent and 15 percent.

Posted Date: 1/31/2013 1:00:38 AM | Location : United States







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