X Company must decide whether to continue using its current equipment or replace

Question

X Company must decide whether to continue using its current equipment or replace it with new, more efficient equipment. The current equipment will last for six more years and has a current disposal value of $10,000. The new equipment will cost $160,000 and will also last for six years. The disposal value of the current and new equipment will be zero at the end of six years. Operating costs with the current equipment are $62,000 and operating costs with the new equipment are $34,310. If X Company replaces the current equipment, what is the approximate internal rate of return?

Explanation / Answer

Cash flows:

immediate or year 0: -160000 + 10000

year 1: -34310 + 62000

year 2: -34310 + 62000

year 3: -34310 + 62000

year 4: -34310 + 62000

year 5: -34310 + 62000

year 6: -34310 + 62000

for IRR, NPV = 0

so

(-160000+10000) + (-34310 + 62000)/(1+i) + (-34310 + 62000)/(1+i)^2 + (-34310 + 62000)/(1+i)^3 + (-34310 + 62000)/(1+i)^4 + (-34310 + 62000)/(1+i)^5 + (-34310 + 62000)/(1+i)^6 = 0

-150000 + 27690/(1+i)^1 + 27690/(1+i)^2 + 27690/(1+i)^3 + 27690/(1+i)^4 + 27690/(1+i)^5 + 27690/(1+i)^6 = 0

solving this equation we get i = 0.03 or i = 3%

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