Henrie’s Drapery Service is investigating the purchase of a new machine for cleaning and blocking drapes. The machine would cost $171,650, including freight and installation. Henrie’s estimated the new machine would increase the company’s cash inflows, net of expenses, by $50,000 per year. The machine would have a five-year useful life and no salvage value.

Henrie’s Drapery Service is investigating the purchase of a new machine for cleaning and blocking drapes. The machine would cost $171,650, including freight and installation. Henrie’s estimated the new machine would increase the company’s cash inflows, net of expenses, by $50,000 per year. The machine would have a five-year useful life and no salvage value.

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 14%, 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 $44,130 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
	=	$171,650	= 3.433
		$50,000

Looking in Exhibit 13B-2 and scanning along the 5-period line, a factor of 3.433 represents an internal rate of return of 14%.

 

2.

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

	Now			Years 1-5
Purchase of machine	$	(171,650	)
Annual cash inflows				$	50,000
Total cash flows (a)	$	(171,650	)	$	50,000
Discount factor (b)		1.000			3.433
Present value (a) × (b)	$	(171,650	)	$	171,650
Net present value	$	0

The reason for the zero net present value is that 14% (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
	=	$171,650	= 3.890 (rounded)
		$44,130

Looking in Exhibit 13B-2 and scanning along the 5-period line, a factor of 3.890 corresponds to the factor for 9%. Thus, the internal rate of return is 9%.

Thanks