CFA CFA Level 1 Calculate the IRR when given terminal growth rate?

Calculate the IRR when given terminal growth rate?

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    • Avatar of leonidas17leonidas17
      Participant
        • CFA Level 1
        Up
        81
        ::

        Hi,

        How should the IRR be calculated with the following information?

        Cash flows:
        Year 0 ($500k)
        Year 1 $10k
        Year 2 ($50k)
        Year 3 $5k
        Year 4 $20k
        Y5 onwards 50k (with terminal growth rate of -5%)

        and discount rate of 15%.

        Any help is very much appreciated.
        Thanks.

      • Avatar of googs1484googs1484
        Participant
          • CFA Level 3
          Up
          3
          ::

          Year 5 is a perpetuity so calculate the PV of that to year 5. Then plug in the cash flows for years 1 thru 4 and then the PV of the perpetuity to CF5. Then use IRR function.  

        • Up
          3
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          Hi @leonidas17, as @googs1484 mentioned you should first calculate the Terminal Value in Year 5 for the 5th year cash flow input.

          It seems that your PV for Y5 is incorrect, I’ll have a go at detailing my steps below:

          Step 1: Calculate Terminal Value at Year 5

          Using the Gordon Growth model, TV = [Final year projected Cash Flow * (1 + r)] / (r – g), where r is discount rate, g is long term cash growth rate. 

          So TV = (50,000) * (1-5%) / (15% + 5%)  –> note: the terminal growth rate g is -5% (not 5%)
                    = 237,500

          Step 2: Input these CF values in CF worksheet

          For BA II plus calculator, make sure you clear your CF worksheet before you start a new calculation (always a good practice!!), by pressing the “2ND” “CE|C” button for CLR WORK function.

          So currently your cash flow (undiscounted) are as follows for the CF function:

          CF0 = -$500,000
          CF1 = $10,000
          CF2 = -$50,000
          CF3 = $5,000
          CF4 = $20,000
          CF5 TV = $237,500 (not sure how you got your $1m number here with PV either?)

          Step 3: Calculate IRR

          Based on these input, I got an answer of -14.22% IRR. Is this correct?

        • Avatar of leonidas17leonidas17
          Participant
            • CFA Level 1
            Up
            1
            ::

            I’ve calculated the:

            PV of Y1 to Y4 = -$14,388.89 ; using the discount rate of 15%.
            PV of Y5 onwards = $1 million ; using rate of 5% (is this correct??)

            What should I do next?

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