Question

Next Service Centre is considering purchasing a new computer network for $82,000. It will require additional working capital of $13,000. Its anticipated eight-year life will generate additional client revenue of $33,000 annually with operating costs, excluding depreciation, of $15,000. At the end of eight years, it will have a salvage value of $9,500 and return $5,000 in working capital Taxes are not considered. Required: a.If the company has a required rate of return of 14%, what is the net present value of the proposed investment? b.What is the internal rate of return?

Answer 1

Cost of new computer network = $82,000

Working Capital requirement = $13,000

Annual Cash Flows = $33,000 - $15,000 i.e. $18,000

Life of computer network = 8 years

Salvage value of network after 8 years = $9,500

Working Capital return after 8 years = $5,000

Required rate of return = 14%

(a) PV of cash Inflows = PV of Annual cash inflows + PV of Salvage Value + PV of Working capital return

= ($18,000 * 4.639) + [($9,500 + $5,000) * 0.351]

= $83,502 + $5,089.50

= $88,591.50

Net Present Value = Initial Cash Outflows - PV of Net Cash Inflows

= $82,000 + $13,000 - $88,591.50

= -$6,408.50

(b) NPV is negative at 14%. This implies that IRR is less than 14%

Applying hit and trial method

IRR = Base Percentage + (NPV at base percentage / Difference in NPV at 12% and 13%)

120% Cost of network $ 82,000.00 Working Capital Requirement | $ 13,000.00 Net Annual Cash Flow $ 18,000.00 Salvage Value $ 9,500.00 Working Capital Return $ 5,000.00 NPV 10% Factor @10% PV Factor @ 12% PV 11 $ 82,000.00 11 $ 82,000.00 1 $ 13,000.00 1 $ 13,000.00 5.334926198 $ 96,028.67 4.967639767 $ 89,417.52 0.46650738 $ 4,431.820.403883228 $ 3,836.89 0.46650738 $ 2,332.54 0.4038832281 $ 2,019.42 | $ 7,793.03 $ 273.82 13% Factor @ 13% PV 1 $ 82,000.00 1 $ 13,000.00 4.798770294 $ 86,377.87 0.376159862 $ 3,573.52 0.376159862 $ 1,880.80 $ -3,167.82

IRR = 12% + [$273.82 / ($273.82 + $3,176.82)]

= 12% + 0.07956%

= 12.08%