Geheller Drilling is looking to purchase a new piece of equipment. The cost of t

Question

Geheller Drilling is looking to purchase a new piece of equipment. The cost of the equipment is $500,000. This equipment does not have any salavage value, but it is depreciated over 10 years. This equipment increases the efficency of the company, and therefore, sales are projected to increase by $1,000,000. Additionally, the profit margin is not expected to change from 15%. Geheller Drilling uses a discount rate of 10% for assessing new projects.

(1)Using a cashflow worksheet, determine the NPV and IRR of the project.

(2)What are the NPV and IRR of this project if the discount rate is 15%?

Explanation / Answer

Additional profit after tax =$ 150,000

Additional annual depreciation of $ 50,000

Therefore incremental annual cash flows $ 200,000

Calculation of NPV

Calculation of IRR:

Step 1: Calculate the fake payback value.

Fake payback value is calculated as Initial outlay/ annual cash flows = 500,000/ 200,000 =2.5

The PV factor closest to 2.5 against 10 years is 2.527 at 38%

I would put the IRR at 38.25%

Period Annual cash flows PV factor at 10% Present value at 10% PV factor at 15% Present value at 15% 0 (500,000) 1 (500,000) 1 (500,000) 1 200,000 0.909 181,800 0.870 174,000 2 200,000 0.826 165,200 0.756 151,200 3 200,000 0.751 150,200 0.658 131,600 4 200,000 0.683 136,600 0.572 114,400 5 200,000 0.621 124,200 0.497 99,400 6 200,000 0.564 112,800 0.432 86,400 7 200,000 0.513 102,600 0.376 75,200 8 200,000 0.467 93,400 0.327 65,400 9 200,000 0.424 84,800 0.284 56,800 10 200,000 0.386 77,200 0.247 49,400 NPV 728,800 NPV 503,800

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