Question

ch 7

Your firm spends $ 454 ,000 per year in regular maintenance of its equipment. Due to the economic​ downturn, the firm considers forgoing these maintenance expenses for the next 3 years. If it does​ so, it expects it will need to spend $ 2.2 million in year 4 replacing failed equipment.  

a. What is the IRR of the decision to forgo maintenance of the​ equipment?

b. Does the IRR rule work for this​ decision?

c. For what costs of capital​ (COC) is forgoing maintenance a good​ decision?

What is the IRR of the decision to forgo maintenance of the​ equipment?_____

Answer 1

My C0=0, C1=+454,000, C2=+454,000,C3=+454,000,C4=-2,200,000

Note from year 1 to 3, we are saving $454,000 by not spending on maintenence capex.

IRR is defines as rate at which you Inflows become equal to Outflows and Net present value of these future cash flows become zero., Hence this the Return on investment where there is no gain or loss.

IRR=C0+C1/(1+r)+C2/(1+r)2+C3/(1+r)3+C4/(1+r)4

0=454,000+454,000/(1+r)2+454,000/(1+r)3-2,200,000/(1+r)4

You have to use your financial calculator/Excel to do this as it will require hit and trial for find rate of internal return(r).

1) From Hit and trial IRR comes out to be 25.97%.

NPV of C1=360,392.097

C2=286,084.721

C3=227,098.398

C4=-873,575.216

2) The IRR is one of the toll of Capital budgeting and since maintenance capex is a part of reoccuring expense it will give an idea for mantaining the cash flows timings, but this will not give you the idea whether my decisoion of investing after year 3 has given be positive value to negative and which could only be founded out using NPV method using discounting the cashflows based on WACC or cost of capital.

3) For cost of capital less than IRR calculated which is 25.97% the decison of forgoing the capex maintence will give positive NPV and hence will add value to organization.

4) When the organization makes decison to forgo maintenance capex for year 4 also than

My C0=0, C1=+454,000, C2=+454,000,C3=+454,000,C4=+2,200,000

IRR=C0+C1/(1+r)+C2/(1+r)2+C3/(1+r)3+C4/(1+r)4

0=454,000+454,000/(1+r)2+454,000/(1+r)3+2,200,000/(1+r)4

As you can se in the formula that there is not atlest one negative IRR so a unique value is not possible in case when all the cash flows are positive.