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

# Calculate the IRR when given terminal growth rate?

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• 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.

• 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.

• 3

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?

• 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?