BASIC INTERNAL RATE OF RETURN ANALYSIS

Smokey Thomas, owner of Steam Whistle Company, was approached by a local dealer of air- conditioning units. The dealer proposed replacing Stream Whistle's old cooling system with a modern, more efficient system. The cost of the new system was quoted at $96,660, but it would save $20,000 per year in energy costs. The estimated life of the new system is 10 years, with no salvage value expected. Excited over the possibility of saving $20,000 per year and having a more reliable unit, Smokey requested an analysis of the project's economic viability. All capital projects are required to earn at least the firm's cost of capital, which is 10 percent. There are no income taxes.

Required:

1. Calculate the project's IRR. Should the company acquire the new cooling system?

2. Suppose that energy savings are less than claimed. Calculate the minimum annual cash savings that must be realized for the project to earn a rate equal to the firm's cost of capital.

3. Suppose that the life of the new system is overestimated by two years. Repeat Requirements 1 and 2 under this assumption.

4. Explain the implications of the answers from Requirements 1, 2, and 3.