A Western Canadian producer is considering purchasing a five-year product licence from Sunkist Growers Inc. The product licence will cost $1,000,000$1,000,000 , and the required equipment will cost $0.5$0.5 million. Equipment upgrades will be $100,000$100,000 at the beginning of the third and fifth years. Expected profits are $500,000$500,000 million in each of the first three years and $400,000$400,000 in the last two years. The producer will purchase product licences only if the IRRIRR is greater than 15%15% . Should the product licence be purchased?Find the internal rate of return (IRR)(IRR) .The producer will purchase product licences only if the IRRIRR is greater than 15%15% . Should the product licence be purchased? No, the product licence should not be purchased since IRR<15%IRR<15% . Yes, the product licence should be purchased since IRR>15%IRR>15% .
Question
A Western Canadian producer is considering purchasing a five-year product licence from Sunkist Growers Inc. The product licence will cost 1,000,000 , and the required equipment will cost 0.5 million. Equipment upgrades will be 100,000 at the beginning of the third and fifth years. Expected profits are 500,000 million in each of the first three years and 400,000 in the last two years. The producer will purchase product licences only if the IRRIRR is greater than 15%15% . Should the product licence be purchased?Find the internal rate of return (IRR)(IRR) .The producer will purchase product licences only if the IRRIRR is greater than 15%15% . Should the product licence be purchased? No, the product licence should not be purchased since IRR<15%IRR<15% . Yes, the product licence should be purchased since IRR>15%IRR>15% .
Solution
The question is asking whether the producer should purchase the product license based on the Internal Rate of Return (IRR). The IRR is a financial metric that is widely used in capital budgeting and corporate finance. It is an estimate of the profitability of potential investments.
Here are the steps to calculate the IRR:
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Identify the cash flows: The cash flows include the initial investment of 0.5 million for the equipment. There are also equipment upgrades of 500,000 in each of the first three years and $400,000 in the last two years.
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Calculate the net cash flow for each year: This is done by subtracting the costs from the profits for each year.
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Use the IRR formula: The IRR is the discount rate that makes the net present value (NPV) of all cash flows (both positive and negative) from a particular project equal to zero.
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Compare the IRR with the required return: If the IRR is greater than the required return of 15%, then the producer should purchase the product license. If the IRR is less than 15%, then the producer should not purchase the product license.
Without the actual calculations, we cannot definitively say whether the product license should be purchased or not. However, this is the process that the producer would use to make that decision.
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