Henrie’s Drapery Service is investigating the purchase of a new machine for cleaning and blocking drapes.

Henrie’s Drapery Service is investigating the purchase of a new machine for cleaning and blocking drapes. The machine would cost $122,570, including freight and installation. Henrie’s estimated the new machine would increase the company’s cash inflows, net of expenses, by $34,000 per year. The machine would have a five-year useful life and no salvage value.

Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using table.

Required:

1. What is the machine’s internal rate of return? (Round your answer to whole decimal place i.e. 0.123 should be considered as 12%.)

2. Using a discount rate of 12%, what is the machine’s net present value? Interpret your results.

3. Suppose the new machine would increase the company’s annual cash inflows, net of expenses, by only $32,330 per year. Under these conditions, what is the internal rate of return? (Round your answer to whole decimal place i.e. 0.123 should be considered as 12%.)

Explanation

1.

Factor of the internal rate of return	=	Investment required
		Annual net cash inflow
	=	$122,570	= 3.605
		$34,000

Looking in Exhibit 13B-2 and scanning along the 5-period line, a factor of 3.605 represents an internal rate of return of 12%.

2.

The machine’s net present value is computed as follows:

	Now			Years 1-5
Purchase of machine	$	(122,570	)
Annual cash inflows				$	34,000
Total cash flows (a)	$	(122,570	)	$	34,000
Discount factor (b)		1.000			3.605
Present value (a) × (b)	$	(122,570	)	$	122,570
Net present value	$	0

The reason for the zero net present value is that 12% (the discount rate we have used) represents the machine’s internal rate of return. The internal rate of return is the discount rate that results in a zero net present value.

3.

Factor of the internal rate of return	=	Investment required
		Annual net cash inflow
	=	$122,570	= 3.791 (rounded)
		$32,330

Looking in Exhibit 13B-2 and scanning along the 5-period line, a factor of 3.791 corresponds to the factor for 10%. Thus, the internal rate of return is 10%.