Delta Inc. is considering the purchase of a new machine which is expected to inc

Question

        Delta Inc. is considering the purchase of a new machine which is   expected to increase sales by $10,000 in addition to increasing   non-depreciation expenses by $3,000 annually. Due to the sales increase,   Delta expects its working capital to increase $1,000 during the life of the   project. Delta will depreciate the machine using the straight-line method   over theproject's five year life to a salvage value of zero. The machine's   purchase price is $20,000. The firm has a marginal tax rate of 34 percent,   and its required rate of return is 12 percent.         The machine's IRR is:           less than 0.
       greater than 12 percent.
       less than 12 percent.
       equal to 12 percent.

Explanation / Answer

Hi,

Please find the answer as follows:

Annual Cash Inflows = (10000 - 3000-20000/5)*(1-.34) = 1980 + 20000/5 = 5980

Initial Cash Outlow = -20000-1000

Final Year Cash Inflow = 5980 + 1000 = 6980 (Because of Recovery of Working Capital)

To calculate IRR, you need to put the value of NPV as 0 and use trial and error method with the use of following equation

NPV = 0 = -21000 + 5980/(1+r)^1 + 5980/(1+r)^2 + 5980/(1+r)^3 + 5980/(1+r)^4 + 5980/(1+r)^5,

Solving for r, we get IRR as 14.10%

Therefore, Machine's IRR is greater than 12%

Answer is greater than 12%.

Thanks.

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