Question

Scotia Family Health Team is investigating purchasing an ultrasound machine for use in its patient clinic. The machine would cost $97,900, including invoice cost, freight, and the training of employees to operate it. Scotia has estimated that the new machine would increase the company’s cash flows, net of expenses, by $17,000 per year. The machine would have a nine-year useful life with no expected salvage value. (Ignore income taxes.) (Hint: Use Microsoft Excel to calculate the discount factor(s).)

Required: 1. Compute the machine’s IRR. (Do not round intermediate calculations and round your final answer to nearest whole number.)

2. Compute the machine’s net present value. Use a discount rate of 10%. (Do not round intermediate calculations and round your final answers to the nearest dollar amount.)

3. Suppose that the new machine would increase the company’s annual cash flows, net of expenses, by only $15,000 per year. Under these conditions, compute the internal rate of return. (Do not round intermediate calculations and round your final answer to nearest whole number.)

Answer 1

1.         Using the IRR formula in Microsoft Excel, the internal rate of return is 10%.

2.

Item	Year(s)	Amount of Cash Flows	Present Value of Cash Flows
Initial investment......................	Now	$(97,900)	$(97,900)
Net annual cash inflows...........	1-9	$17,000	97,903
Net present value......................			$ 3

The reason for the almost zero net present value is that 10% (the discount rate) represents the machine’s internal rate of return. The internal rate of return is the rate that causes the present value of a project’s cash inflows to just equal the present value of the investment required.

3.   

Using the IRR formula in Microsoft Excel, the internal rate of return is 7%. The lower IRR is the direct result of cash flows decreasing by $2,000 per year over the life of the project.