Your firm is contemplating the purchase of a new $663,000 computer-based order e

Question

Your firm is contemplating the purchase of a new $663,000 computer-based order entry system. The system will be depreciated straight-line to zero over its six-year life. It will be worth $52,000 at the end of that time. You will save $172,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $47,000 at the beginning of the project. Working capital will revert back to normal at the end of the project.

If the tax rate is 35 percent, what is the IRR for this project?

Your firm is contemplating the purchase of a new $663,000 computer-based order entry system. The system will be depreciated straight-line to zero over its six-year life. It will be worth $52,000 at the end of that time. You will save $172,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $47,000 at the beginning of the project. Working capital will revert back to normal at the end of the project.

Explanation / Answer

Solution:

Calculate the annual depreciation of the new equipment.

Annual depreciation = Asset Value / Life of the Asset

Annual depreciation = $663,000 / 6

Annual depreciation = $110,500

After-tax salvage value of the equipment

Aftertax salvage value = $52,000(1 – 0.35)

Aftertax salvage value = $33,800

Using the tax shield approach, the OCF

OCF = $172,000(1 – 0.35) + 0.35($110,500)OCF

    = $150,475

The IRR of the project

NPV = 0 = –$663,000 + 47,000 + $150,475(PVIFAIRR%,6) + [($33,800 – 47,000) / (1+IRR)6]

= –$663,000 + 47,000 + $150,475(2.3852) + [($33,800 – 47,000) / (1+IRR)6]

= 257,087 + [($33,800 – 47,000) / (1+IRR)6]

IRR =6.48%

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