Question

The table below offers EBIT for a potential capital investment for Fake Company Zeta. (This same project will be used for all of your FMC #3 work.) You should be able to determine a few things once you consider the following:

• The initial investment is $20,000.
• Depreciation is straight line over four years.
• The company's WACC is estimated at 9.25%.
• Company analysts estimate that a proper salvage value at the end of the project life of four years is 30% of the initial investment.
• The company's tax rate is 30.0%.

	YEAR 1	YEAR 2	YEAR 3	YEAR 4
EBIT	$(1,750)	$325	$1,025	$3,700

What is this project's internal rate of return?

Answer 1

Time line		0	1	2	3	4
Cost of new machine		-20000
=Initial Investment outlay		-20000
=Pretax cash flows			-1750	325	1025	3700
-taxes	=(Pretax cash flows)*(1-tax)		-1225	227.5	717.5	2590
+Depreciation			5000	5000	5000	5000
=after tax operating cash flow			3775	5227.5	5717.5	7590
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)					4200
+Tax shield on salvage book value	=Salvage value * tax rate					0
=Terminal year after tax cash flows						4200
Total Cash flow for the period		-20000	3775	5227.5	5717.5	11790
Discount factor=	(1+discount rate)^corresponding period	1	1.101939809	1.21427134	1.33805393	1.47445489
Discounted CF=	Cashflow/discount factor	-20000	3425.776951	4305.05095	4272.99667	7996.17543
NPV=	Sum of discounted CF=	5.78843E-06
IRR is discount rate at which NPV = 0 =	10.19%