Question

1. The ABC Company is looking at a new piece of equipment with an installed cost of $187,400. This cost will be depreciated straight-line to zero over the four-year life. At the end of the four years the book value will be zero however it can be scrapped for $25,000. The equipment will save the firm $99,000 per year in pre-tax operating costs and the equipment requires an initial investment in net working capital of $9,000 and will be recovered at the end of the project. If the tax rate is 34% and the discount rate is 12%, what is the NPV of this project?

What is the Internal Rate of Return for this project?

Answer 1

Answer:

Initial Investment = $187,400
Useful Life = 4 years

Annual Depreciation = Initial Investment / Useful Life
Annual Depreciation = $187,400 / 4
Annual Depreciation = $46,850

Initial Investment in NWC = $9,000

Salvage Value = $25,000

After-tax Salvage Value = $25,000 * (1 - 0.34)
After-tax Salvage Value = $16,500

Annual Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Annual Operating Cash Flow = $99,000 * (1 - 0.34) + 0.34 * $46,850
Annual Operating Cash Flow = $99,000 * 0.66 + 0.34 * $46,850
Annual Operating Cash Flow = $81,269

Year 0:

Net Cash Flows = Initial Investment + Initial Investment in NWC
Net Cash Flows = -$187,400 - $9,000
Net Cash Flows = -$196,400

Year 1 to Year 3:

Net Cash Flows = Operating Cash Flow
Net Cash Flows = $81,269

Year 4:

Net Cash Flows = Operating Cash Flow + NWC recovered + After-tax Salvage Value
Net Cash Flows = $81,269 + $9,000 + $16,500
Net Cash Flows = $106,769

Answer a.

Required Return = 12%

Net Present Value = -$196,400 + $81,269/1.12 + $81,269/1.12^2 + $81,269/1.12^3 + $106,769/1.12^4
Net Present Value = $66,648.06

Answer b.

Let IRR be i%

Net Present Value = -$196,400 + $81,269/(1+i) + $81,269/(1+i)^2 + $81,269/(1+i)^3 + $106,769/(1+i)^4
0 = -$196,400 + $81,269/(1+i) + $81,269/(1+i)^2 + $81,269/(1+i)^3 + $106,769/(1+i)^4

Using financial calculator, i = 26.63%

Internal Rate of Return = 26.63%