Question

Henrie’s Drapery Service is investigating the purchase of a new machine for cleaning and blocking drapes. The machine would cost $137,280, including freight and installation. Henrie’s has estimated that the new machine would increase the company’s cash inflows, net of expenses, by $40,000 per year. The machine would have a five-year useful life and no salvage value.

Required:

1. Compute the machine’s internal rate of return to the nearest whole percent.

2. Compute the machine’s net present value. Use a discount rate of 14%. Why do you have a zero net present value?

3. Suppose that the new machine would increase the company’s annual cash inflows, net of expenses, by only $37,150 per year. Under these conditions, compute the internal rate of return to the nearest whole percent.

Answer 1

1.

Present value of annuity = $137,280 / $40,000

= 3.432

At 14% for 5 years the present value of annuity is 3.432

Internal rate of return = 14%

2.

At internal rate of return the present value of cash inflows is equal to present value of cash outflows.

Internal rate of return = 14%

Discount rate = 14%

Net Present Value = $0

When internal rate of return and discount rate are same, net present value will be zero.

3.

Present value of annuity = $137,280 / $37,150

= 3.695

At 11% for 5 years the present value of annuity is 3.695

Internal rate of return = 11%