Riverview Company is evaluating the proposed acquisition of a new production mac

Question

Riverview Company is evaluating the proposed acquisition of a new production machine. The machine's base price is $200,000, and installation costs would amount to $28,000. Also, $10,000 in net working capital would be required at installation. The machine will be depreciated for 3 years using simplified straight line depreciation. The machine would save the firm $110,000 per year in operating costs. The firm is planning to keep the machine in place for 5 years. At the end of the fifth year, the machine will be sold for $20,000. Riverview has a cost of capital of 12% and a marginal tax rate of 34%.

What is the IRR of the project?

A. 31.3%

Explanation / Answer

The Correct Option is C: 28.2%

Working:

Calculation of Dep.:

Cost + Installation Cost / Life in Years

200,000 + 28,000 / 3 = $76,000 Per Year

Calculation of Net Saving For the 5 Years:

Calculation of IRR:

Calculation of Present Value:

IRR is the rate which equals Present Value of Inflow and Outflow.

Total outflow = 200,000 + 28,000 + 10,000 = $238,000

PV of Inflow at 20% = $283,594.38

Which is more than the PV of Outflow, So IRR must be more than 20%

PV of Inflow at 30% = $231,827.36

Which is less than the PV of Outflow, So, IRR must be less than 30%

Rate between 20 and 30% = 28.2%

Amount($)(For Year 1-3) Amount(4 Year) Amount($)(For Year 5) Saving in Operating Cost 110,000 110,000 110,000 - Dep. 76,000 - - Net Saving 34,000 110,000 110,000 - Tax 11,560 37,400 37,400 Income After tax 22,440 72,600 72,600 + Dep. 76,000 - Net Cash Flow 98,440 72,600 72,600 + Salvage Value 20,000 + Release of Working Capital 10,000 Total Cash Flow 102,600

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