Question

Project EvaluationYour firm is contemplating the purchase of a new $575,000 computer-based order entry system. The system will be depreciated straight-line to zero over its 5-year life. It will be worth $60,000 at the end of that time. You will save $176,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $80,000 (this is a one-time reduction). If the tax rate is 23 percent, what is the IRR for this project? Chapter 6 question 7

Answer 1

Annual depreciation charge = $575,000 / 5 = $115,000

After-tax salvage value = $60,000(1 - 0.23) = $46,200

OCF = [Annual Savings x (1 - t)] + [t * Depreciation]

= [$176,000(1 - 0.23)] + [0.23($115,000)] = $135,520 + $26,450 = $161,970

Now we can find the project IRR. There is an unusual feature that is a part of this project. Accepting this project means that we will reduce NWC. This reduction in NWC is a cash inflow at Year 0. This reduction in NWC implies that when the project ends, we will have to increase NWC. So, at the end of the project, we will have a cash outflow to restore the NWC to its level before the project. We also must include the after-tax salvage value at the end of the project.

Cash Flow at Year 0 = -$575,000 + $80,000 = -$495,000

Cash Flow at Year 5 = $161,970 + $46,200 - $80,000 = $128,170

To find the IRR, we need to put the following values in the financial calculator:

CF0 = -495,000; C01 = 161,970; F01 = 4; C02 = 128,170; F02 = 1; Press IRR, then CPT, which gives 17.70%