Your firm is contemplating the purchase of a new $763000 computer-based order en

Question

Your firm is contemplating the purchase of a new $763000 computer-based order entry system. The system will be depreciated straight-line to zero over its seven-year life. It will be worth $49,000 at the end of that time. You will save $169,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $44,000 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%, what is the IRR for this project?

Explanation / Answer

The calculation of IRR is as below

IRR for this project = 11.79%

Note: WC is an acronym for working capital, since there is a saving in WC at the beginning we have added it and since the WC reverts to normal at the end, we have reduce it

The depreciation is 763000/7 = 109000 per year over 7 years

Year 0 1 2 3 4 5 6 7 Initial Cost -763000 Initial WC Savings 44000 Savings per year 169000 169000 169000 169000 169000 169000 169000 Depreciation -109000 -109000 -109000 -109000 -109000 -109000 -109000 Salavage Value 49000 Profit before tax 60000 60000 60000 60000 60000 60000 109000 Tax @ 20% -12000 -12000 -12000 -12000 -12000 -12000 -21800 Profit after tax 48000 48000 48000 48000 48000 48000 87200 Add Back Depreciation 109000 109000 109000 109000 109000 109000 109000 WC back to normal -44000 Operating Cash flow -719000 157000 157000 157000 157000 157000 157000 152200 IRR 11.79%

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