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Net investment, net cash flows, net present value and the Internal Rate of Return

1. The capital budgeting department is contemplating whether to purchase a piece of equipment. The new piece of equipment costs $900,000. The equipment currently being used by the firm would be replaced by the new and would be sold for $100,000 which is the firm's book value for the asset. The estimated useful life of the new equipment is 3 years. The firm's capital gain tax rate is 20% and their ordinary tax rate is 40%. The new equipment is not expected to have a salvage value at the end of its useful life and the firm uses straight-line depreciation.

Estimated Earnings:

Year Without the new equipment With the new equipment
1 $500,000 $1,200,000
2 $700,000 $1,500,000
3 $900,000 $1,900,000

Depreciation Information
Year Without the new equipment With the new Equipment
1 $200,000 $500,000
2 $250,000 $550,000
3 $300,000 $600,000

Calculate the net investment, net cash flows, the net present value and the Internal Rate of Return on this project assuming an 8% cost of capital.

Solution Preview

1. Net Investment = $900,000 - 100,000*(1-40%) = $840,000

2. Net Cash Flows = Increase in cash flow*(1-t) + Increase in depreciation * t
Year Cash flow:
1 (1,200, ...

Solution Summary

The solution shows all the calculations to arrive at the correct answers.

$2.19