Question

Is there a business case for the following project?

You have been assigned to manage a project to upgrade all your company's data centre servers with new models. Each new server will cost you $25,000 to purchase, and you need 10 of them in total. Each new server comes with three years' free maintenance worth $2,500/year (you'll have to pay this in the fourth and fifth years). Each new server saves you $2,000/year in electrical costs. Each new server saves you $1,000/year in air conditioning expenses.

The required Internal Rate of Return (IRR) on this project, over a five year period, is 15% above breakeven. It will take you $15,000/month for three months to install the new machines. (The old ones are scrap and have no value.) After that you have no further project expenses.

Using a discount rate of 2.5% to do the discounted cash flows, is there a case for this project (it meets or exceeds the IRR) or not?

Answer 1

Part A of Answer: When IRR is 15%

Year	0	1	2	3	4	5
Cost of new servers	(250,000)
	(43,898)
Saving on Maintenance		25,000	25,000	25,000
Saving of eletrical cost		20,000	20,000	20,000	20,000	20,000
Saving of air conditioning expenses		10,000	10,000	10,000	10,000	10,000
Total Cash Flow	(293,898)	55,000	55,000	55,000	30,000	30,000
IRR	-9.24%
Working Note: Present value calculation when IRR is 15%
one month investment	15,000
	Annual IRR	Monthly IRR
Internal Rate of Return (IRR)	15%	1.25%
Month	1	2	3
Present Value	14,815	14,632	14,451
Total Present value for three months	43,898

As, caluculated IRR is just 9.24% which is less than required IRR of 15% so project should not be accepted.

Following picture shows all excel formulas used in above calcualtion:

Part B of Answer: When IRR is 2.5%

Year	0	1	2	3	4	5
Cost of new servers	(250,000)
	(44,813)
Saving on Maintenance		25,000	25,000	25,000
Saving of eletrical cost		20,000	20,000	20,000	20,000	20,000
Saving of air conditioning expenses		10,000	10,000	10,000	10,000	10,000
Total Cash Flow	(294,813)	55,000	55,000	55,000	30,000	30,000
IRR	-9.34%
Working Note: Present value calculation when IRR is 15%
one month investment	15,000
	Annual IRR	Monthly IRR
Internal Rate of Return (IRR)	2.5%	0.21%
Month	1	2	3
Present Value	14,969	14,938	14,907
Total Present value for three months	44,813

As, caluculated IRR is just 9.34% which is less than required IRR of 15% so project should not be accepted.

Following picture shows all excel formulas used in above calcualtion: