A project requires an initial investment of $200,000 and expects to produce a cash flow before taxes of $120,000 per year for two years . The corporate tax rate is 21 percent. The assets will depreciate using the MACRS year 3 schedule: (t = 1: 33%); (t = 2: 45%); (t = 3: 15%); (t = 4: 7%). The company's tax situation is such that it can use all applicable tax shields. The opportunity cost of capital is 11 percent. Assume that the asset can sell for book value at the end of the project. Calculate the approximate IRR for the project.
A)12.00 percent
B)11.00 percent
C)20.02 percent
D)14.06 percent

Question

Quizplus · Accepted Answer

We can calculate the incremental cash flows for each year using the given information and formula: 
Incremental cash flow = (Cash flow before taxes - Depreciation expense) x (1 - Corporate tax rate) + Depreciation expense 
Year 1: (120,000 - 66,000) x (1 - 0.21) + 66,000 = 96,840 
Year 2: (120,000 - 90,000) x (1 - 0.21) + 90,000 = 118,800 
Year 3: (120,000 - 30,000) x (1 - 0.21) + 30,000 = 97,200 
Year 4: (120,000 - 14,000) x (1 - 0.21) + 14,000 = 97,680

The initial investment of $200,000 is a negative cash flow in Year 0.

We can now calculate the IRR using a financial calculator or Excel. The approximate IRR for this project is 20.02 percent. Therefore, the best choice is C.

A Project Requires an Initial Investment of $200,000 and Expects