Velma and Keota (V&K) is a partnership that owns a small company. It is considering two alternative investment opportunities. The first investment opportunity will have a five-year useful life, will cost $19,680.96, and will generate expected cash inflows of $4,800 per year. The second investment is expected to have a useful life of three years, will cost $12,885.48, and will generate expected cash inflows of $5,000 per year. Assume that V&K has the funds available to accept only one of the opportunities.
Required
a. Calculate the internal rate of return of each investment opportunity.
b. Based on the internal rates of return, which opportunity should V&K select?
c. Discuss other factors that V&K should consider in the investment decision.
SOLUTION
a. Determination of the annuity table values can be accomplished by dividing the cost of the investment by the annuity:
First investment: $19,680.96 ÷ $4,800 = 4.1002. Locating this value in Table 2 indicates that the investment is expected to earn an internal rate of return approximating 7%.
Second investment: $12,885.48 ÷ $5,000 = 2.577096. Locating this value in Table 2 indicates that the investment is expected to earn an internal rate of return approximating 8%.
b. Since the second investment has a higher internal rate of return it should be accepted.
c. Many other factors should be considered.
(1) The life of the investments. The second investment has a three-year useful life. If the company is unable to reinvest funds at greater than 7% at the end of three years, its effective rate of return for the second investment could fall below the return generated by the first investment.
(2) The size of the investment. If the company has $19,680.96 (i.e., amount of the first investment opportunity) of funds available to invest and only invests $12,885.48 (i.e., amount of the second investment opportunity), then $6,795.48 ($19,680.96 $12,885.48) of uninvested funds will exist. If these funds are not invested at a rate greater than 8%, the overall return from the residual funds and the second investment could fall below 8%.
(3) Confidence in the accuracy of projected cash flows. Uncertainty is just another word for risk. If the projections for one investment are less certain than the other, this risk factor should be considered in the final decision.