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Project Evaluation Your firm is contemplating the purchase of a new £925,000 con based order entry system
Project Evaluation Your firm is contemplating the purchase of a new £925,000 con based order entry system. The system will be depreciated straight-line to zero over its five life. It will be worth £90,000 at the end of that time. You will save £360,000 before tax year in order processing costs, and you will be able to reduce working capital by £125,000 is a one-time reduction). If the tax rate is 35 percent, what is the IRR for this project?
Expert Solution
ANS:
Net Cash Flow at Year 0 = - Purchase Price + Reduction in Working Capital
= - 925,000 + 125,000
= - 8,00,000
Annual depreciation Charge = Purchase Price / Useful Life
= 9,25,000 / 5
= 1,85,000
After Tax Salvage Value = Salvage Value at the end * (1 - tax rate)
= 90,000 * (1- 0.35)
= 58,500
So, Using Tax Shield Approach,
Operating Cash Flow (OCF) upto 4th year = Saving before tax * ( 1 - tax rate) + Annual depreciation * tax rate
= 3,60,000 * ( 1 - 0.35) + 1,85,000 * 35%
= 234,000 + 64,750
= 298,750
Operating Cash Flow (OCF) of 5th year = OCF of 4th year - Reduction in Working Capital + After Tax Salvage Value
= 2,98,750 - 1,25,000 + 58,500
= 2,32,250
Now, Calculation of Internal Rate of Return (IRR)
Here, We can use Excel Formula, "IRR" i.e =IRR(values, [guess])
| Year | Net Operating Cash Flow (OCF) |
| 0 | -8,00,000 |
| 1 | 2,98,750 |
| 2 | 2,98,750 |
| 3 | 2,98,750 |
| 4 | 2,98,750 |
| 5 | 2,32,250 |
So, As per Excel "IRR" formula, IRR = 23.85% or 24% (approax)
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