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Calculate the IRR when given terminal growth rate?

leonidas17leonidas17 MalaysiaPosts: 2 Associate
edited November 2015 in CFA Level I
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.
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Comments

  • 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.  
  • 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?
  • 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?
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