Question

Project Evaluation Your firm is contemplating the purchase of a new £925,000 computer-based order entry system. The system will be depreciated using reducing balance at 20 per cent per annum over its five-year life. It will be worth £90,000 at the end of that time. You will save £360,000 before taxes per year in order processing costs, and you will be able to reduce working capital by £125,000 (this is a one-time reduction). If the tax rate is 28 per cent, what is the IRR for this project?

Answer 1

IRR = 25.49%

Formula	Year (n)	0	1	2	3	4	5
	Initial investment (II)	925,000
	Savings per annum (S)		360,000	360,000	360,000	360,000	360,000
BVn = BVn-1 - Dn	Book value (BV)	925,000	740,000	592,000	473,600	378,880	90,000
Dn = 20%*BVn-1	Depreciation (D)		185,000	148,000	118,400	94,720	288,880
S*(1-Tax rate) +(D*Tax rate)	Operating cash flow (OCF)		311,000	300,640	292,352	285,722	340,086
This reduction will be returned at the end of life	Reduction in NWC ('R)	125,000					(125,000)
Tax effect is already adjusted in the depreciation calculation	Salvage value (SV)						90,000
SV + R + OCF - II	Free Cash Flow (FCF)	(800,000)	311,000	300,640	292,352	285,722	305,086
Using IRR() function on FCFs	IRR	25.49%

The only point of note in this calculation is the Year 5 depreciation expense. It will be calculated as (20% of book value at the end of Year 4) + tax loss from selling for 90,000. Tax loss = book value at the beginning of Year 5 - selling price

Total depreciation expense in Year 5 = (20%*378,800) + (80%*378,800 - 90,000) =

75,776 + 213,104 = 288,880.