Homeland Security Systems Equipment $40,000 Year Cash Flow 1 $20,000 2 $18,000 3

Question

Homeland Security Systems Equipment $40,000 Year Cash Flow 1 $20,000 2 $18,000 3 $13,000 STEP 1: Average the inflows STEP 2: Divide investment by annuity from step 1 STEP 3: Find the rate that corresponds to the value in Step 2: STEP 4: Calculate the Present Value at 14% Because the inflows are biased toward the early years, we will use the higher rate of 14%. Year Cash Flow PVIF @ 14% Present Value 1 2 3 STEP 5: Calculate the Present Value at 15% Since the NPV is slightly over $40,000, we need to try a higher rate. We will try 15%. Year Cash Flow PVIF @ 15% Present Value 1 2 3 PV @ 14% PV @ 15% PV @ 14% Cost IRR = b) With a cost of capital of 12 percent, should the machine be purchased? Explain:

Explanation / Answer

IRR = Lower Rate + (NPV at Lower Rate / Lower Rate NPV-Higher Rate NPV) * Difference in Rates

= 14 + (168.90+450.40) * 1

= 14.27%

Since IRR is more than the cost of capital of 12%, it is advisable to purchase the machine.

Year Cash Flows PVF@14% PV@14% PVF@15% PV@15%        1    20,000.00     0.88 17,543.86     0.87 17,391.30        2    18,000.00     0.77 13,850.42     0.76 13,610.59        3    13,000.00     0.67     8,774.63     0.66     8,547.71 Present Value 40,168.90 39,549.60 Cash Outflow 40,000.00 40,000.00 Net Present Value(NPV)    168.90       -450.40

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