Your firm is contemplating the purchase of a new $530,000 computer-based order e

Question

Your firm is contemplating the purchase of a new $530,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $50,000 at the end of that time. You will save $310,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $65,000 (this is a one-time reduction). If the tax rate is 34 percent, what is the IRR for this project? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Explanation / Answer

First, we will calculate the annual depreciation of the new equipment. It will be:

Annual depreciation charge = $530,000/5 = $106,000

The after-tax salvage value of the equipment is:
After tax salvage value = $50,000 * (1-0.34) = $33,000

Using the tax shield approach, the OCF is:
OCF = $310,000*(1-0.34) + 0.34*($106,000) = $240,640

OCF in year 5 = $240,640 + $33,000 - $65,000 = $208,640

0 = -$530,000 + $65,000 + [($240,640)/(IRR)] + [($240,640)/(IRR)2] + [($240,640)/(IRR)3] + [($240,640)/(IRR)4] + [($208,640)/(IRR)5] = 42.4205%

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