Question

Your firm is contemplating the purchase of a new $530,000 computer-based order entry system. The system will be depreciated straight-line to zero over its 7-year life. It will be worth $75,000 at the end of that time. You will save $185,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $50,000 at the beginning of the project. Working capital will revert back to normal at the end of the project. If the tax rate is 25 percent, what is the IRR for this project?

Note: Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.

should be a percentage

Answer 1

To calculate the IRR for the computer-based order entry system project, we consider the initial investment, annual operational savings, tax savings due to depreciation, and changes in working capital. The IRR is the discount rate that equates the present value of these future cash flows to the initial investment. This requires an iterative calculation that is best done with financial software.

Step-by-step explanation:

The project of purchasing a new computer-based order entry system involves various cash flows and savings which we need to factor in to calculate the Internal Rate of Return (IRR):

• Initial investment of $530,000.
• Annual savings of $185,000 before taxes.
• Depreciation of the system over its 7-year life (straight-line), leading to an annual depreciation expense of $75,714.29 (($530,000 - $75,000) / 7).
• The salvage value at the end of the 7th year, totaling $75,000.
• The reduction of working capital by $50,000 at the beginning of the project, which is reverted back at the end of the project.
• A tax rate of 25 percent.

To calculate the IRR, we establish the net cash flows for each year considering tax savings from depreciation and operational savings, and then we solve for the discount rate that makes the sum of the present value of future cash flows equal to the initial investment.

The calculation is complex and requires the use of financial software or a financial calculator, as the IRR is found through iterative methods. It is not straightforward to compute in a step-by-step manual process, particularly because tax savings, depreciation, and changes in working capital all influence the annual net cash flow differently each year.