Your Firm Is Considering The Purchase Of A New 600,000 Comp

Your Firm Is Contemplating The Purchase Of A New 600000 Computer Bas

Your firm is contemplating the purchase of a new $600,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $64,000 at the end of that time. You will save $230,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $79,000 (this is a one-time reduction). If the tax rate is 30 percent, what is the IRR for this project?

Paper For Above instruction

Calculating the Internal Rate of Return (IRR) for a capital investment project involves evaluating the cash flows generated by the project and determining the discount rate at which the net present value (NPV) of these cash flows equals zero. In this case, the project entails purchasing a computer system costing $600,000, depreciated straight-line over five years, with a salvage value of $64,000 at the end of the period. Additionally, the project is expected to generate annual pre-tax savings of $230,000 and involve a one-time working capital reduction of $79,000. The corporate tax rate is 30%, which impacts the after-tax cash flows and depreciation tax shield considerations. The goal is to find the project's IRR, which represents the rate of return that equates the initial investment with the present value of all future after-tax benefits and salvage proceeds.

Introduction

The assessment of investment projects through IRR provides a crucial metric for decision-making, especially when evaluating capital expenditures like the purchase of new computer systems. The IRR reflects the project's expected profitability by identifying the discount rate that results in a zero NPV. This paper calculates the IRR for the proposed computer system purchase, incorporating all relevant cash flows, depreciation effects, tax implications, and working capital changes.

Analysis of Investment Components

The initial investment comprises the $600,000 purchase cost. Since depreciation is straight-line over five years, annual depreciation expense equals $600,000 / 5 = $120,000. The salvage value at the end of five years is $64,000, which influences the terminal cash flows. The depreciation expense provides a tax shield each year, reducing taxable income and thus taxes payable. The project also yields annual pre-tax savings of $230,000, directly impacting cash flows. Because these savings are before taxes, they will be adjusted for taxes to determine the after-tax savings.

Tax Adjustment and Depreciation Benefits

The annual pre-tax savings of $230,000 are taxed at 30%, leading to after-tax savings of $230,000 × (1 - 0.3) = $161,000. The depreciation tax shield, which reduces taxable income, is calculated as depreciation expense × tax rate, i.e., $120,000 × 0.3 = $36,000. This shield increases cash flow because it reduces the taxes owed. Additionally, at the project's end, the salvage value along with the remaining book value influences the final cash flow, considering tax effects on salvage proceeds.

Cash Flows Calculation

Yearly after-tax cash flows include the after-tax savings plus depreciation tax shield. Therefore, annual net cash inflow is $161,000 + $36,000 = $197,000.

The initial outlay includes the purchase cost and the reduction in working capital, resulting in a net initial investment of $600,000 - $79,000 = $521,000. Since the working capital reduction is a cash inflow at inception, it effectively reduces the initial outlay.

At the end of the project life (year 5), the salvage value of $64,000 will be realized. Taxes on salvage are calculated based on the book value at that time. The book value after five years of straight-line depreciation is zero, so the entire salvage value is taxable, leading to taxes of $64,000 × 0.3 = $19,200. The net cash inflow from salvage is therefore $64,000 - $19,200 = $44,800.

In addition, the working capital reduction of $79,000 is recovered at year 5, providing an additional cash inflow.

Calculating the IRR

Summing all these cash flows over the project's lifespan allows us to compute the IRR. The cash flow timeline is established as follows:

• Year 0: Initial investment of $521,000 (cost minus working capital reduction)
• Years 1-5: Annual after-tax savings of $161,000, plus depreciation shield of $36,000, totaling $197,000 per year
• Year 5: Salvage value of $64,000, taxes on salvage of $19,200, net salvage cash flow of $44,800, and recovery of working capital of $79,000

Using these figures, the IRR is the discount rate that satisfies the equation where the net present value of these cash flows equals zero. This can be solved through financial software or iterative methods such as the trial-and-error process or the IRR function on financial calculators or spreadsheet software.

Conclusion

Based on the detailed cash flow analysis, the IRR indicates the project's profitability. If the IRR exceeds the company's required rate of return, the project is considered financially viable. Conversely, if it falls below the required threshold, it should be rejected. An approximate IRR calculation for this project, considering the numbers derived, suggests a rate of around 20-25%, which typically exceeds standard corporate hurdle rates, thus supporting proceeding with the investment.

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