The Jill Company is examining purchasing a new piece of equipment. Jill, the owner, has a problem in that she only can make decisions using Excel and they have told her that the compute system will be down for the next month.
She has hired you to evaluate the proposal and make the final recommendation as she sits in her office staring at a blank computer screen.
The old system is currently three years old and had an original production life of eight years. It had cost $4, 800,000 and was being depreciated as 7-year Straight-Line property. Jill estimated that it could be sold for $300,000 at the end of its production life and this is still true.
The new will take one year to build and install and require an investment of $1, 700,000 today and $1, 900,000 one year from now, have a production life of six years and be depreciated as 7-year MACRS. It will also increase working capital by $100,000 when it is ready for use.
The old is projected to produce revenue of $2, 400,000 this coming year and that will decrease 15% per year for the rest of its production life. Expenses are expected to be 50% of revenue (not including depreciation and taxes).
The old will be used until the new is put in service. The new will produce $1, 900,000 its first year of production, $3, 100,000 its second year, $3, 700,000 its third year, $2, 900,000 its fourth year, $2, 450,000 its fifth year and $1, 845,000 its last year. Expenses are expected to be 45% of revenue (not including depreciation and taxes).
We expect to sell it for $800,000 at the end of its production life. We estimate we can sell the working capital for $95,000 at that time. Jill estimates that the old could be sold for $1, 375,000 when the new is ready for use.
Jill requires a 16% return on this project and has a 35% tax rate. Based on net present value, should she purchase the new system? Also compute the profitability index. !
The IRR on this project would be: