Question

Kwik-E-Mart, Inc. is considering the purchase of a $500,000 computer that has an economic life of 5 years. The computer falls into the MACRS 5-year class and will be sold in 5 years for $100,000. The use of the computer will save five office employees whose combined annual salaries are $120,000 (don’t worry, Apu will keep his job). It also contributes to lower net working capital by $100,000 when they buy the computer. The net working capital will be recovered at the end of the project. The corporate tax rate is 34%.

Is it worthwhile to buy the computer if the appropriate discount rate is 12%? Use the internal rate of return method.

Answer 1

Operating cash flow (OCF) each year = income after tax + depreciation

In year 0, the computer contributes to lower net working capital. Hence, the initial investment is decreased since funds are released from working capital.  In year 5, the entire working capital investment is recovered, which means that the working capital is restored to its original level before the computer was purchased. Hence, this is a cash outflow since funds are invested back into working capital.

profit on sale of equipment at end of year 5 = sale price -book value

book value = original cost - accumulated depreciation

after-tax salvage value = salvage value - tax on profit on sale of equipment   

IRR is calculated using IRR function in Excel

IRR is 11.16%

It is not worthwhile to buy the computer because the IRR is lower than the discount rate