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March 30, 2017

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Dr. Whitten has decided to purchase equipment that has a cost of $60,000 and will produce a pretax net cash inflow of $30,000 per year over its estimated useful life of six years. The equipment will have no salvage value and will be depreciated by the straight-line method. The tax rate is 50%. Determine Dr. Whitten’s approximate after-tax internal rate of return.

  • Finance - ,

    Assemble the assumptions in an orderly manner:
    Assumption 1: initial cost of the investment = $60,000.
    Assumption 2a: estimated annual net cash inflow the investment will generate = $30,000.
    Assumption 2b: estimated annual net cash inflow the investment will generate after taxes =
    $15,000 (e.g. 30,000 less 50% tax rate equals 15,000 net).
    Assumption 3: useful life of the asset = 10 years.
    Perform calculation
    Step 1. Divide the initial cost of the investment ($15,000) by the estimated annual net cash
    inflow after taxes it will generate ($15,000). The answer is a ratio amounting to 4.000.
    Step 2. Now use the abbreviated look-up table for the Present Value of an Annuity of $1,
    which is found at the back of the Examples and Exercises section. Find the line item for the
    number of periods that matches the useful life of the asset (10 years in this case).
    Step 3. Look across the 10 year line on the table and find the column that approximates the
    ratio of 4.000 (as computed in Step 1). That column contains the interest rate representing the
    rate of return. In this case the rate of return is 20%.

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