Question

Palestine Corp. needs to purchase new plastic moulding machines to meet the demand for its
product. The cost of the equipment is $3,724,000. It is estimated that the firm will increase after tax cash
flow (ATCF) by $700,601 annually for the next 6 years. The firm is financed with 40% debt and 60%
equity, both based on current market values, though the firm has announced that it wants to quickly
change its debt to equity ratio to 1.5. The firm's beta is 0.91, the risk free rate is 0.70% and the expected
market return is 3.69%. Palestine Corp.'s semi-annual bonds have 14.20% coupons, 16 years to
maturity, and a quoted price of 97.168. Assume the firm's tax rate is 34%. The firm's last 5 dividends (the
last in the list is D0) are 1.23, 1.26, 1.45, 1.90, and 1.91. Its current market price is $99.31.
Question 3, Short Answer C: Assume that there are some large cleanup and disposal costs of $372,400 at
the end of the project (in year 7). Explain in a sentence or two how this impacts the calculation of the internal
rate of return? Note that no additional calculation is required to answer this question.

Answer 1

In case the internal rate of return is r at the beginning (not accounting for disposal of assets at the end of year 7), we've:

In this case, putting in the values,

On solving, eq (i):

Let us account for disposal costs of $372,400 at the end of year 7. In case the internal rate of return is R now,

On solving, eq (ii):

On comparing the two eq's:

Clearly, the equation is going to be satisfied for R < r. In case, R = r, the last term on RHS becomes equal to 0 which is not feasible. In case, R > r, leaving the last term on RHS, the RHS is going to be already less than LHS, and furthermore on subtracting the last term on RHS. Hence, the internal rate of return decreases as an impact of disposal costs.