Olsen Inc. purchased a $600,000 machine to manufacture a specialty tap for electrical equipment. The tap is in high demand and Olsen can sell all that it could manufacture for the next 10 years. To encourage capital investments, the government exempts taxes on profits from new investments in this type of machinery. This legislation most likely will remain in effect in the foreseeable future. The equipment is expected to have 10 years of useful life and no salvage value at the end of this 10-year period. The firm uses straight-line depreciation. The net cash inflow is expected to be $144,000 each year. Olsen uses a discount rate of 10% in evaluating its capital investments.

The estimated internal rate of return (IRR) on this proposed investment is: (Note: the PV annuity factor from Table 2, Appendix C, 10%, 10 years is 6.145.)

Question

The estimated internal rate of return (IRR) on this proposed investment is: (Note: the PV annuity factor from Table 2, Appendix C, 10%, 10 years is 6.145.)

Quizplus · Accepted Answer

The net cash inflow for the next 10 years is $144,000 per year, therefore the total cash inflow is $1,440,000 ($144,000 x 10). The initial cost of the equipment is $600,000. The equipment's salvage value is zero. The straight-line depreciation expense per year is ($600,000/10 = $60,000).
Using the formula: 
IRR = Initial Investment / Annual Cash Inflow x PV Annuity factor.
IRR = $600,000 / $144,000 x 6.145
IRR = 25.29%
Since the IRR (25.29%) is greater than the required rate of return (10%), the investment is acceptable. Therefore, the answer is D) Greater than 12%.

Olsen Inc Purchased a $600,000 Machine to Manufacture a Specialty Tap