You are deciding between two mutually exclusive investment opportunities. Both require the same initial investment of $10 million. Investment A will generate $2.3 million per year (starting at the end of the first year) in perpetuity. Investment B will generate $1.8 million at the end of the first year, and its revenues will grow at 3.3% per year for every year after that. Use the incremental IRR rule to correctly choose between investments A and B when the cost of capital is 7.2%. At what cost of capital would your decision change

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Parrain Parrain · Answer 1 · 2022-03-30T16:14:18+02:00

Using the incremental IRR rule, the investment that should be chosen at 7.2% cost of capital is Investment A.

The cost of capital that the decision would change is 15.8%.

Find the cost of capital by equating both values:

Value of perpertuity = Value of growth perperturity

2.3 million / Cost of capital = 1.8 million / (Cost of capital - 3.3% growth rate)

2.3 x Cost of capital - 0.0754 = 1. 8 x cost of capital

(2.3 - 1.8) x cost of capital = 0.0754

Cost of capital = 15.18%

The incremental IRR rule would mean that:

For any rate that is above 15.18%, Investment B should be selected as it would bring a positive return.

Rates below 15.18% should lead to Investment A selected as it would bring a positive return.

At a rate of 7.2% therefore, Investment A should be chosen.

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