Question

Nancy's Notions pays a delivery firm to distribute its products in the metro area. Delivery costs are $32,000 per year. Nancy can buy a used truck for $13,000 that will be adequate for the next 3 years. Operating and maintenance costs are estimated to be $21,000 per year. At the end of 3 years, the used truck will have an estimated salvage value of $2,000. Nancy's MARR is 34%/year.

a. What is this investment's internal rate of return? IRR = J% Do all calculations to 5 decimal places and round final answer to the whole number. The tolerance is +/- 1.
b. What is the decision rule for judging the attractiveness of investments based on internal rate of return?
c. Should Nancy buy the truck?

Answer 1

a. Internal Rate of Return

Annual Cash Inflows = (Net Savings - Depreciation) * ( 1 - Tax Rate) + (Depreciation * Tax Rate)

Net savings = Delivery Costs - Operating and Maintenance Costs with the Used Truck

= 32,000 - 21,000

= $11,000

Depreciation = (Cost of used truck - Salvage value) / Useful life

= (13,000 - 2,000) / 3

= $3,667

Annual Cash inflows = $7,000 as there are no taxes.

Use Excel to calculate IRR as shown in the attachment.

The cost of the truck is the outflow and the savings and the salvage value are inflows which means that the last inflow will be $13,000 because salvage value is added in the last year.

IRR = 69.408%

b. If the IRR is greater than the cost of capital or required rate of return, the project should be chosen.

c. The IRR of 69.408% is greater than the MARR of 34% so Nancy should buy the truck.