IRR: Even Cash Flows
Williams and Park Accounting Practice is considering investing in a new computer system that costs $9,000 and would reduce processing costs by $2,000 a year for the next six years.
Required:
Calculate the internal rate of return, using the time value of money charts. Round your answer to the nearest whole number. Do not round your interim calculations. Do not enter the percent sign (%).
To calculate the internal rate of return (IRR) for an investment, you need to determine the discount rate that makes the net present value (NPV) of the investment equal to zero. In this case, the investment is the cost of the computer system ($9,000), and the cash flows are the annual savings from reduced processing costs ($2,000) over a six-year period.
To calculate the IRR, you can follow these steps:
1. List the cash flows:
Year 0 (initial investment): -$9,000
Years 1 to 6: +$2,000 (annual savings)
2. Use a financial calculator or spreadsheet software to find the IRR. However, since you requested to use time value of money charts, I'll explain how to approximate the IRR using trial and error with those charts.
3. On the time value of money chart (also known as a present value or discounted cash flow chart), locate the factor for the cash flows listed in step 1. The factor for year 0 will be negative, representing the initial investment, while the factors for years 1 to 6 will be positive, representing the annual savings.
4. Choose an approximate discount rate from the chart and compute the present value of the cash flows by multiplying the cash flows by their corresponding factors. Sum up the present values for all the cash flows.
5. If the sum of the present values is close to zero, then you have found an approximate IRR. Otherwise, repeat step 4 with a different discount rate until you find the discount rate that yields a sum of present values close to zero.
6. Once you have found a discount rate with a sum of present values close to zero, round it to the nearest whole number and that will be your approximate IRR.
Note: Keep in mind that using time value of money charts to calculate the IRR can only give you an approximate answer. For a more precise calculation, using a financial calculator or spreadsheet software is recommended.