Question

Internal Rate of Return Analysis. Wood Products Company would like

to purchase a computerized wood lathe for $100,000. The machine is

expected to have a life of 5 years, and a salvage value of $5,000. Annual

maintenance costs will total $20,000. Annual net cash receipts resulting

from this machine are predicted to be $45,000. The company’s required

rate of return is 15 percent.

Required:

a. Use trial and error to approximate the internal rate of return for this

investment proposal.

b. Should the company purchase the wood lathe? Explain.

Answer 1

Internal rate of return is the rate of return at which Net Present value = 0

i.e. Present Value of Cash outflows = present value of cash inflows

a.Let IRR be x%

Hence, 100,000 = (45,000-20,000)*PVAF(x%, 5 years) + 5,000*PVF(x%, 5 years)

Let x = 12%

NPV = 25,000*3.605 +5,000*0.567 – 100,000

$(7,040)

At x = 10%

NPV = 25,000*3.791 +5,000*0.621 – 100,000

=$(2,120)

At x = 8%

NPV = 25,000*3.993 +5,000*0.681 – 100,000

=$3,230

IRR, by interpolation, = 8% + (3,230/5,350)*2%

=9.21% (Approx.)

b. The company should not purchase the wooden lathe since IRR is less than the required rate of returm.