First lets understand what the question means. Let’s say we are having two business models and we need to invest money in to the same. Below figure ‘Investment models’ shows the same in a pictorial format. The first investment model is to open a grocery shop and the second investment model is to buy a car. All the investment in to both the businesses are shown by negative (-) sign i.e. it signifies that cash has flown out. While positive (+) sign signifies that we have received money from the business in other words it’s the profit.
So for the grocery business:-
The total profit after the sale of grocery items is 400000. The second investment model is of a car business.
The rent received or the profit in the car business is 360000.
Note :- One of the important point to be noted is we can not use PV,FV and rate formula as they are used only when cash flows are even. In this case the cash flows are uneven so this will need a different approach.
The current example is very simple and has hardly three or four transactions. You can easily guess which business is good by simple maths. In real world scenario entries can go in thousand and it will be difficult to predict which business model is feasible. The best way to predict any business growth is by the rate of return it gives. So if we are able to calculate the rate of return from both these business we can easily decide which investment we should go for. Rate of return can be calculated by using the IRR formula.
Figure: - Investment models
Below figure ‘IRR in action’ shows how we can use the IRR formulae. We just need to select the full range and input the same in the IRR formula.
Figure: - IRR in action
So finally calculating the rate of return we find that the grocery investment gives more return than the car investment.
Figure: - Rate of return