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

Calculate the IRR when given terminal growth rate?

  • Author
    Posts
    • leonidas17
      Participant
      Up
      79
      Down

      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.

    • googs1484
      Participant
      Up
      3
      Down

      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.  

    • leonidas17
      Participant
      Up
      1
      Down

      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?

    • Sophie Macon
      Keymaster
      Up
      3
      Down

      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?

Viewing 3 reply threads
  • You must be logged in to reply to this topic.