Your firm is contemplating the purchase of a new $1,628,000 computer-based order

Question

Your firm is contemplating the purchase of a new $1,628,000 computer-based order entry system. The system will be depreciated straight-line to zero over its 5-year life. It will be worth $158,400 at the end of that time. You will save $633,600 before taxes per year in order processing costs and you will be able to reduce working capital by $115,764 (this is a one-time reduction). The net working capital will return to its original level when the project ends. The tax rate is 35 percent. What is the internal rate of return for this project? 18.21 percent 11.78 percent 13.49 percent 23.58 percent 21.65 percent

Explanation / Answer

Answer is : 21.65 percent Annual depreciation charge = $1628000/5 = $325600 Aftertax salvage value = $158400(1 – 0.35) = $102960 Using the tax shield approach, the OCF = $633600(1 – 0.35) + 0.35(325600) OCF = $525800 Now we can find the project IRR. There is an unusual feature that is a part of this project. Accepting this project means that we will reduce NWC. This reduction in NWC is a cash inflow at Year 0. This reduction in NWC implies that when the project ends, we will have to increase NWC. So, at the end of the project, we will have a cash outflow to restore the NWC to its level before the project. We also must include the aftertax salvage value at the end of the project. The IRR of the project is: NPV = 0 = –1628000 + 115,764+ 525800(PVIFAIRR%,5) + [($102960 – 115,764) / (1+IRR)^5] IRR = 21.65%

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