Question

Exercise 14: Your firm is contemplating the purchase of a new $425,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $30,000 at the end of that time. You will save $130,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $60,000 (this is a one-time reduction). If the tax rate is 35 percent, what is the IRR for this project?

Exercise 15: In the previous problem, suppose your required return on the project is 11 percent and your pretax cost savings are $150,000 per year. Will you accept the project? What if the pretax cost savings are $100,000 per year? At what level of pretax cost savings would you be indifferent between accepting the project and not accepting it?

At what level of pretax cost savings would you be indifferent between accepting the project and not accepting it?

Answer 1

Solution

Ex.14 Calculation of IRR(Internal rate of return)

Internal rate of return is the rate at which sum of present value of cash flows is equal to Initial cash outlay.

a)Initail cash outaly=Cost of system+reduction in working capital

=$425,000+$60,000

=$485,000

b)Annual Depreciation=(Cost of system-salvage value)/life

=$425,000-0/5

=$85,000

c)After tax salvage value of sytem at the end of 5th year

=(Salvage value-book value)*(1-tax rate)

=($30,000-0)(1-0.35)

=$19,500

d)After tax annual cash flows

	Amount($)
Saving before taxes	130,000
Less:depreciation	85,000
Saving after depreciation	45,000
Less:Tax @35%	15,750
Saving after tax	29,250
Add:Depreciation	85,000
After tax cash flows	114,250

Now calculate the present value of after tax cash flows,after salvage value and working capital reduction at the rate of 2% and 5%

Year	Cash flows	Present value factor@	Present value@
		2%	5%	2%	5%
1	114,250	0.980	0.952	111,965.00	108,766.00
2	114,250	0.961	0.907	109,794.25	103624.75
3	114,250	.942	0.864	107,623.50	98,712.00
4	114,250	0.924	0.823	105,567.00	94,027.75
5	114,250	0.906	0.784	103,510.50	89,572.00
salvage value of system	19,500	0.906	0.784	17,667.00	15,288.00
Reversal of Working capital	-60,000	0.906	0.784	-54,360.00	-47040.00
Sum of Present value(total present value)	501,767.25	462,950.50

IRR=Lower rate+[(Total present value at lower rate-Initial cash outlay/Total present value at lower rate-Total present value at higher rate)*Difference between rate]

=2+(501,767.25-$485,000/501,767.25-462,950.50)*3

=2+[(16,767.25/38,816.75)*3]

=3.30%

Thus IRR is 3.30%