Your firm is considering the purchase of a new $780,000 computer-based order ent

ID: 2662481 • Letter: Y

Question

Your firm is considering the purchase of a new $780,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $45,000 at the end of that time. You will save $310,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $55,000 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?

Explanation / Answer

The cash flows with minus signs are cash outflows and cashflow with plus signs is cash inflows.

Particulars

Present year

End of Year 1

End of Year 2

End of Year 3

End of Year 4

End of Year 5

Initial Cost

-$780,000

Salvage Value

$45,000

Saved by order system at tax rate of 35%

$310,000 * (1-0.35) = $201,500

Working Capital

$55,000

-$55,000

Total cash inflows and outflows

-$725,000

$201,500

$191,500

Internal rate of return (IRR) is a discount rate at whichinitial cost is equal to the sum of discounted cash flows, or where net presentvalue (NPV) becomes zero, let’s solve for it:

Let’s first assume a discount rate of 10% or 0.1 andcalculating NPV as shown below:

NPV = -Initial Cost + Discounted cash flows

NPV = -Initial Cost + [CF1 / (1+r) 1]+ [CF2 / (1+r) 2] + [CF3 / (1+r)