Question 18(1 point)

It is common for senior management to impose some type of minimum "internal rate of return (IRR)" requirement on any proposed project. These IRR often will be 15% or more, even if firm's actual borrowing cost is several percentage points lower. This is done to account for the reality that even well-conceived projects sometimes fail and the firm needs to be able to cover those losses. Also, it is to account for the reality that subordinates will try hard to hide risk, in order to get projects approved, in order to fortify their resume, in order to quit the firm for a better job. Standard corporate "cycle of life" stuff.

Suppose you believe the purchase of some equipment will add $3,000 in operating profits (ignoring up-front cost of the equipment) in year 1, $5,000 in year 2, $1,000 in year 3 and then have no further value. If you must use an IRR of 15%, then compute the NPV of $3000 in one year + NPV of $5000 in two years + NPV of $1000 in 3 years at r=15%. Do each of the 3 computations separately using the formula, then add them up. This is the NPV of the benefit of the equipment, the cost up-front of the equipment must be smaller than this value in order for the project to clear the IRR of 15% requirement. So, what is the maximum up-front cost (with a little rounding) for this equipment that will get the project approved?

Question 18 options:

a)

$7050

b)

$8350

c)

$7850

d)

$6350