Question

10.EX.19.09 NPV and IRR

Each of the following scenarios is independent. All cash flows are after-tax cash flows.

Required:
1. Patz Corporation is considering the purchase of a computer-aided manufacturing system. The cash benefits will be $727,000 per year. The system costs $2,738,000 and will last six years. Compute the NPV assuming a discount rate of 12 percent.

Should the company buy the new system?
2. Sterling Wetzel has just invested $309,000 in a restaurant specializing in German food. He expects to receive $49,464 per year for the next nine years. His cost of capital is 7.40 percent. Compute the internal rate of return. Round your answers to whole percentage value (for example, 16% should be entered as "16" in the answer BOX).
%

Answer 1

1. To compute the NPV for the purchase of the computer-aided manufacturing system, we need to discount the cash benefits at the given discount rate and subtract the initial cost. The cash benefits are $727,000 per year for 6 years.

NPV = Cash benefits / (1 + discount rate)^n - Initial cost

NPV = $727,000 / (1 + 0.12)^6 - $2,738,000

Using a calculator, the NPV is approximately -$527,592.78 (rounded to the nearest dollar).

Since the NPV is negative, it indicates that the present value of cash benefits is less than the initial cost. Therefore, based on the NPV criterion, the company should not buy the new system.

2. To compute the internal rate of return (IRR) for Sterling Wetzel's investment in the restaurant, we need to find the discount rate that makes the present value of cash flows equal to the initial investment.

IRR is the rate at which the NPV equals zero.

IRR = Cost of capital

In this case, the initial investment is $309,000 and the cash flows are $49,464 per year for 9 years.

Using a financial calculator or Excel's IRR function, the IRR is approximately 9% (rounded to the nearest whole percentage value).

Therefore, the internal rate of return for Sterling Wetzel's investment is 9%.