Your firm is contemplating the purchase of a new $674,000 computer-based order entry system. The system will be depreciated straight-line to zero over its 6-year life. It will be worth $58,000 at that time. You will save $185,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $29,000 at the beginning of the project. Working capital will revert back to normal at the end of the project. If the tax rate is 34 percent, what is the IRR for this project?

Question

Quizplus · Accepted Answer

The IRR is calculated by finding the discount rate that makes the net present value (NPV) of the project's cash flows equal to zero. The annual depreciation is $112,333.33 ($674,000/6). The annual after-tax savings is $122,100 ($185,000 - $62,900 tax on savings). The annual depreciation tax shield is $38,193.33 ($112,333.33 * 0.34). The total annual cash flow is $160,293.33 ($122,100 + $38,193.33). The initial cash flow is $645,000 ($674,000 - $29,000). The terminal cash flow is $87,000 ($58,000 salvage value + $29,000 working capital recovery). Solving for IRR gives approximately 13.01 percent.

Your Firm Is Contemplating the Purchase of a New $674,000