Question

Henry’s Inc. is considering the acquisition of a new piece of equipment. The machine’s price is $600,000. In addition, installation and transportation costs would be $50,000 and would require $10,000 in spare parts thus increasing the firm’s net working capital by that amount. The system falls into the MACRS 3-year class (depreciation rates of 33%, 45%, 15%, and 7%). The current machine it would replace could be sold for $50,000 and currently has no book value. It is estimated that the new equipment would increase productivity and thus increase the firm's before-tax revenues by $115,000 per year and would also reduce its operating costs by $20,000 per year because its greater speed and efficiency. The equipment is expected to be used for 5 years and then be sold for $45,000. The firm’s marginal tax rate is 26% and Henry’s WACC is 7%.

What is the IRR?

Answer 1

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

total cost of machine = purchase cost + installation cost

Initial investment = total cost of machine - after tax sale price of old machine (book value is zero)

after tax sale price of old machine = sale price * (1 - tax rate)

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

book value is zero as the machine is fully depreciated

after-tax salvage value = salvage value + tax benefit on loss on sale of machine (the loss is tax deductible, and hence reduces the tax outgo. This is treated as a cash inflow)

IRR is calculated using IRR function in Excel

IRR is -3.41%