your firm is considering a new product development. an outlay of $90,000 is requ

Question

your firm is considering a new product development. an outlay of $90,000 is required for equipment, and an additional net working capital of $5000 is required. the project is expected to have a 4 year life, and th equipement will be depreciated on a straight line basis to a $10,000 book value. producing the new product will reduce current manufacturing expenses by $15,000 annually and increase earnings (revenue) before depreciation and taxes by $18,000 annually. stanton's marginal tax rate is 40 percent. stanton expects the equipment will have a marekt salvage value of $10,000 at the end of 4 years

What is the projects IRR? accept or reject the project? Why?

Explanation / Answer

Calculation of IRR:

At 10%:

NPV = PV of Inflow - Outflow

NPV = 95,634.1 - 95,000 = $634.1

So, IRR must be more than 10%

We try now 13%

NPV = 93,493.78 - 95,000 = $1,506.22

So, the IRR must be between 10 and 11%.

By Interpolation:

IRR = 10% + [ 634.1 x (11% - 10%) / [634.1 - (-1,506.22)]

IRR = 10.30%

Accept or Reject Decision: IRR should be compared with the Cost of Capital and if, IRR is more than Cost of Capital than The Project should be accepted and if Cost of Capital is more than IRR, the Project should be rejected.

0 1 2 3 4 Outflow 95,000 Inflow: Reduction in Expenses 15,000 15,000 15,000 15,000 Increase In Earnings 18,000 18,000 18,000 18,000 Less: Depreciation 20,000 20,000 20,000 20,000 Add: Salvage Value - - - 10,000 Net Inflow 13,000 13,000 13,000 23,000 Tax(40%) 5,200 5,200 5,200 9,200 After Tax Flow 7,800 7,800 7,800 13,800 Add: Dep. 20,000 20,000 20,000 20,000 Add: Working Capital - - - 5,000 Net Inflow 27,800 27,800 27,800 38,800 DF(10%) 0.90909 0.82644 0.75131 0.68301 PV OF Inflow 25,273 22,975 20,886.4 26,500 Total PV 95,634.1

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