Question

Your firm is contemplating the purchase of a new $525,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $59,000 at the end of that time. You will save $157,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $84,000 (this is a one-time reduction). If the tax rate is 23 percent, what is the IRR for this project?

Answer 1

	Initial Cash Flow:
	New purchase	($525,000)
	Reduction of working capital	$84,000
	Net Initial Cash flow in year 0	($441,000)
	Annual cash Flow;
	Savings before taxes	$157,000
	After tax annual savings	$120,890	157000*(1-0.23)
	Annual Depreciation	$105,000	(525000/5)
	Annual Depreciation tax shield	$24,150	(105000*0.23)
	Total after tax annual cash flow	$145,040	(120890+24150)
	TerminalCash Flow:
	Before tax salvage value	$59,000
	Taxes on gain on salvage	$13,570	(59000*0.23)
	After tax salvage value	$45,430
	YEAR WISE CASH FLOW:
	YEAR	0	1	2	3	4	5
	Initial Cash Flow	($441,000)
	Annual Cash flow		$145,040	$145,040	$145,040	$145,040	$145,040
	TerminalCash Flow						$45,430
	NET CASH FLOW	($441,000)	$145,040	$145,040	$145,040	$145,040	$190,470
	Internal Rate of Return(IRR)	21.09%	(Using IRR function of excel over the NET CASH FLOW)
	If the initial reduction in working capital needed to be restored back at the end of 5 years
	TerminalCash Flow will be	($38,570)	(45430-84000)
	In this case NET CASH FLOW and IRR will be:
	NET CASH FLOW	($441,000)	$145,040	$145,040	$145,040	$145,040	$106,470
	Internal Rate of Return(IRR)	17.55%