Your firm is contemplating the purchase of a new $663,000 computer-based order e

Question

Your firm is contemplating the purchase of a new $663,000 computer-based order entry system. The system will be depreciated straight-line to zero over its six-year life. It will be worth $52,000 at the end of that time. You will save $172,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $47,000 at the beginning of the project. Working capital will revert back to normal at the end of the project.

Required: If the tax rate is 35 percent, what is the IRR for this project?

Explanation / Answer

Purchase cost of Asset= $663000

Depreciation per year =$663000/6 = $110500

Salvage Value(asset worth)= $52000

Net savings before taxes(assumed before depreciation) per year= $172000

Net reduction in WC= $47000

Tax rate = 35%

Solution:

Outflows = inflows

Purchase cost + reduction in working capital = post tax cash flow net of dep(note -1) * Present Value Interest Factor of Annuity + Salvage Value * Present Value Interest Factor - Working Captial * Present value of Interest Factor

Or, $663000 + $47000 = $150475* PVIFA(x%,6) +$ (52000-47000) * PVIF(x%, 6)

Using trial and error method and using 7.5%,

$710000 =$706300+$3240

so IRR= 7.5%

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