ABC company is considering a new investment that will cost 50,000 to produce a n
ID: 2648054 • Letter: A
Question
ABC company is considering a new investment that will cost 50,000 to produce a new product that the president of the company has invented. The marketing dept of the company anticipates the new cash flows from the investment will be 10,000, 12,000, 12,000 12,000 and 10,000. The newly elected President of the United States has reinstituted the old investment tax incentive for corporations which gives an investment tax credit of 10% of the cost of an investment applicable in the second year after implementation of the investment. It will cost the company 2000 to install the new equipmment in the factor to get it going. The operations officer engineer thinks that the residual value of the equipment will be 10000. That maintenance costs will be 1000 in years 2 and 4 only. The corporate controller says that the accounting department has been using DDB appreciation for all new equipment. Assuming the company can sell bonds at 10% to pay for this investment, is this a good investment for the company? Whether or not, what is the IRR of the new investment?
Explanation / Answer
year 0 1 2 3 4 5 total cost of machine -50000 cash inflow 10000 12000 12000 12000 10000 installation cost -2000 residual value 10000 maintenance cost -1000 -1000 investment tax credit @10% 5200 cost ( 50000+2000) total inflow -52000 10000 16200 12000 11000 20000 pvf at 9% 1 0.909 0.826 0.751 0.683 0.621 present value -52000 9090 13381.2 9012 7513 12420 -583.8 As Net Present Value is negative, therefore this is nota good investment for computing IRR, Internal rate of return is the discount rate at which the present value of all cash inflows equals to that all of cash outflows , i.e , the discount rate at which the net present value becomes zero. therefore to compute IRR, we need to calculate the NPV at different discount rate which gives us a range of NPV from positive to negative values and intrplaote in the range to find out the discount rate at which the NPV becomes zero. in this let us assumed , such higher rate , says 12% total inflow -52000 10000 16200 12000 11000 20000 pvf at 9% 1 0.893 0.797 0.712 0.635 0.567 present value -52000 8930 12911.4 8544 6985 11340 -3289.6 IRR = low rate + { NPV at 9%/(NPV@9% -NPV@10%)} * Difference between high and low rate 10% + -583.8/(583.8 -{- 3289.6}) * 12-10 = 9.57%