Question

Installing an automated production system costing $300,000 is initially expected to save Zia Corporation $52,000 in expenses annually. If the system needs $7,500 in operating and maintenance costs each year and has a salvage value of $30,000 at year 10, what is the IRR of this system? If the company wants to earn at least 12% on all investments, should this system be purchased? (show solution steps using trial and error, Excel-based solutions are not allowed) TYPE THE ANSWER

Answer 1

Ans. Cash flows each year,

Year 0 = -Investment Cost = -300000

Year 1-9 = Savings - Operating expenses = 52000-7500 = $44500

Year 10 = Saving - Operating Expense + Salvage Value = 52000 - 7500 + 30000 = $74500

Internal rate of return is the rate of return at which the net present value of the cash flows is zero, so,

NPV = 0 = -300000 + 44500/(1+IRR) + 44500/(1+IRR)^2 + 44500/(1+IRR)^3 + 44500/(1+IRR)^4 + 44500/(1+IRR)^5 + 44500/(1+IRR)^6 + 44500/(1+IRR)^7 + 44500/(1+IRR)^8 + 44500/(1+IRR)^9 + 74500/(1+IRR)^10

=> IRR = 0.08874 or 8.874%

Thus, internal rate of return (8.874%) is less than the required rate of return on investment (12%), so, this system should not be purchased.

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