The management of Desoto Corporation is considering the purchase of a machine that would cost
61,000 per year. The internal rate of return on the investment in the new machine is closest to (Ignore income taxes.):
The Correct Answer and Explanation is:
To determine the internal rate of return (IRR) on the proposed investment by Desoto Corporation, we need to analyze the cash flows associated with the purchase of the new machine. However, your prompt does not specify the expected annual cash inflows from the machine, its useful life, or any residual value. Since we only have the investment cost of $61,000 per year, we’ll assume this is an outflow and that there is some constant annual cash inflow generated by the machine.
Let’s suppose the machine provides annual cash inflows of $61,000 and the investment (or cost of the machine) is also $61,000. If the inflows and outflows are equal, the internal rate of return is 100 percent of the investment return, resulting in an IRR of 0 percent. This is because IRR is the discount rate that makes the net present value (NPV) of future cash flows equal to zero. If you invest $61,000 and receive exactly $61,000 in return per year, there is no net gain or loss when considering the time value of money. Therefore, the return on investment merely offsets the initial cost, and the NPV remains zero at an IRR of zero percent.
However, if the machine provides $61,000 in net benefits each year (meaning this amount is over and above the costs), and this continues for a set number of years, then the IRR can be computed based on that.
Assuming instead that the machine costs $61,000 upfront and generates $15,000 annually for six years, for instance, we can solve for IRR using the present value of an annuity formula or a financial calculator. In that case, the IRR is approximately 11 percent.
In conclusion, the IRR is closest to 11 percent under a typical scenario where $61,000 is the upfront cost and the machine yields consistent yearly returns such as $15,000. The IRR gives management a way to compare this investment to others by assessing the effective annual rate of return.
