Question

Henrie's Drapery Service is investigating the purchase of a new machine for cleaning and blocking drapes. The machine would cost$137,280, including freight and installation. Henrie's has estimated that the new machine would increase the company's cash inflows, net of expenses, by $40,000 per year. The machine would have a five-year useful life and no salvage value.

 

Required:

1. Compute the machine's internal rate of return to the nearest whole percent.

2. Compute the machine's net present value. Use a discount rate of 14%. Why is the NPV so close to zero?

3. Suppose that the new machine would increase the company's annual cash inflows, net of expenses, by only $37,150 per year. Under these conditions, compute the internal rate of return to the nearest whole percent.

Answer 1

1. Using the IRR formula in Microsoft Excel, the internal rate of return is 14%.

 

2.

Item                      Amount of Cash Flows     Present Value of Cash Flows*

Initial investment          $(137,280)                          $(137,280)

Annual cash inflows        $40,000                              137,323

Net present value                                                        $ 43

 

*Calculated using NPV formula in Microsoft Excel and a 14% required return.

The reason the net present value is so close to zero is that 14% (the discount rate we have used) represents the machine’s internal rate of return. The internal rate of return is the discount rate that results in a zero net present value.

3.

Using the IRR formula in Microsoft Excel results in an internal rate of return of only 11% if the annual cash inflows are only $37,150.

1. The internal rate of return is 14%.

2. The net present value is $43.

3. The internal rate of return is 11%.