Question

Exercise 12-15 Internal Rate of Return and Net Present Value [LO12-2, LO12-3]

Henrie’s Drapery Service is investigating the purchase of a new machine for cleaning and blocking drapes. The machine would cost $126,175, including freight and installation. Henrie’s estimated the new machine would increase the company’s cash inflows, net of expenses, by $35,000 per year. The machine would have a five-year useful life and no salvage value.

Click here to view Exhibit 12B-1 and Exhibit 12B-2, to determine the appropriate discount factor(s) using table.

Required:

1. What is the machine’s internal rate of return? (Round your answer to whole decimal place i.e. 0.123 should be considered as 12%.)

2. Using a discount rate of 12%, what is the machine’s net present value?

3. Suppose the new machine would increase the company’s annual cash inflows, net of expenses, by only $32,435 per year. Under these conditions, what is the internal rate of return? (Round your answer to whole decimal place i.e. 0.123 should be considered as 12%.)

	1. Internal rate of return % 2. Net present value 3. Internal rate of return %

Problem 12-17 Net Present Value Analysis; Internal Rate of Return; Simple Rate of Return [LO12-2, LO12-3, LO12-6]

Casey Nelson is a divisional manager for Pigeon Company. His annual pay raises are largely determined by his division’s return on investment (ROI), which has been above 24% each of the last three years. Casey is considering a capital budgeting project that would require a $5,850,000 investment in equipment with a useful life of five years and no salvage value. Pigeon Company’s discount rate is 20%. The project would provide net operating income each year for five years as follows:

Sales			$	5,200,000
Variable expenses				2,320,000
Contribution margin				2,880,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs	$	880,000
Depreciation		1,170,000
Total fixed expenses				2,050,000
Net operating income			$	830,000

Click here to view Exhibit 12B-1 and Exhibit 12B-2, to determine the appropriate discount factor(s) using tables.

Required:

1. What is the project’s net present value?

2. What is the project’s internal rate of return?

3. What is the project’s simple rate of return?

4-a. Would the company want Casey to pursue this investment opportunity?

4-b. Would Casey be inclined to pursue this investment opportunity?

Answer 1

Solution 12-15-1:

Let IRR of machine = i

Now at IRR, present value of cash inflows are equal to initial investment

Therefore

$35,000 * Cumulative PV Factor at i for 5 periods = $126,175

Cumulative PV Factor at i for 5 periods = 3.605

Refer PV Factor table, the PV Factor falls at i = 12%

Hence IRR = 12%

Solution 12-15-2:

Using 12% discount rate, machine net present value = 0 as discount rate is equal to IRR

Solution 12-15-3:

Let IRR of machine = i

Now at IRR, present value of cash inflows are equal to initial investment

Therefore

$32,435 * Cumulative PV Factor at i for 5 periods = $126,175

Cumulative PV Factor at i for 5 periods = 3.890

Refer PV Factor table, the PV Factor falls at i = 9%

Hence IRR = 9%

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