Question

Your firm is contemplating the purchase of a new $600,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $60,000 at the end of that time. You will save $200,000 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 21 percent, what is the IRR for this project?

Answer 1

Time line		0	1	2	3	4	5
Cost of new machine		-600000
Initial working capital		80000
=Initial Investment outlay		-520000
Profits			200000	200000	200000	200000	200000
			0	0	0	0	0
-Depreciation	Cost of equipment/no. of years		-120000	-120000	-120000	-120000	-120000
=Pretax cash flows			80000	80000	80000	80000	80000
-taxes	=(Pretax cash flows)*(1-tax)		63200	63200	63200	63200	63200
+Depreciation			120000	120000	120000	120000	120000
=after tax operating cash flow			183200	183200	183200	183200	183200
reversal of working capital							-80000
+Tax shield on salvage book value	=Salvage value * tax rate						0
=Terminal year after tax cash flows							-80000
Total Cash flow for the period		-520000	183200	183200	183200	183200	103200
Discount factor=	(1+discount rate)^corresponding period	1	1.1960426	1.43051791	1.7109604	2.0463815	2.447559
Discounted CF=	Cashflow/discount factor	-520000	153171.8	128065.506	107074.37	89523.874	42164.45
NPV=	Sum of discounted CF=	2.195E-06
IRR is discount rate at which NPV = 0 =	19.60%