Kemp Co. is contemplating the purchase of a new $1,000,000 computer-based order entry system. The system...

Kemp Co. is contemplating the purchase of a new $1,000,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $200,000 at the end of that time. You will save $400,000 before taxes per year in order processing costs and you will be able to reduce working capital by $100,000 (this is a one-time reduction at the start and no return to initial state at the end of the system's life). Suppose the required rate of return on this system is 12 percent and the tax rate is 30%. what is the IRR of the system?

Expert Solution

Time line		0	1	2	3	4	5



Cost of new machine		-1000000
Initial working capital		100000
=Initial Investment outlay		-900000



Savings			400000	400000	400000	400000	400000


-Depreciation	Cost of equipment/no. of years		-200000	-200000	-200000	-200000	-200000

=Pretax cash flows			200000	200000	200000	200000	200000
-taxes	=(Pretax cash flows)*(1-tax)		140000	140000	140000	140000	140000
+Depreciation			200000	200000	200000	200000	200000
=after tax operating cash flow			340000	340000	340000	340000	340000

reversal of working capital							0

+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)						140000
+Tax shield on salvage book value	=Salvage value * tax rate						0
=Terminal year after tax cash flows							140000

Total Cash flow for the period		-900000	340000	340000	340000	340000	480000
Discount factor=	(1+discount rate)^corresponding period	1	1.280879	1.640652	2.1014777	2.6917397	3.4477941
Discounted CF=	Cashflow/discount factor	-900000	265442.6	207234.7	161790.91	126312.36	139219.45
NPV=	Sum of discounted CF=	8.966E-05
IRR is discount rate at which NPV = 0 =	28.09%

jeff jeffy answered 1 year ago

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