Miami Machine Shops, Ltd., is considering purchasing a vertical drill machine. The machine will cost $62,000 and will have an eight-year service life. The selling price of the machine at the end of eight years is expected to be $5,000 in today's dollars. The machine will generate annual revenues of $22,000 (today's dollars), but the company expects to have an annual expense (excluding depreciation) of $9,500 (today's dollars). The asset is classified as a seven-year MACRS property. The project requires a working-capital investment of $10,000 at year 0. The marginal income tax rate for the firm is averaging 135%. The firm's market interest rate is 18%.
(a) Determine the internal rate of return of this investment.
(b) Assume that the firm expects a general inflation rate of 5%. but that it also expects an 8% annual increase in revenue and working capital and a 6% annual increase in expense caused by inflation. Compute the real (inflation-free) internal rate of return. Is this project acceptable?