Question

Cost Reduction Proposal: IRR, NPV, and Payback Period JB Chemical currently discharges liquid waste into Calgary's municipal sewer system. However, the Calgary municipal government has informed JB that a surcharge of $4 per thousand cubic liters will soon be imposed for the discharge of this waste. This has prompted management to evaluate the desirability of treating its own liquid waste. A proposed system consists of three elements. The first is a retention basin, which would permit unusual discharges to be held and treated before entering the downstream system. The second is a continuous self-cleaning rotary filter required where solids are removed. The third is an automated neutralization process required where materials are added to control the alkalinity-acidity range. The system is designed to process 500,000 liters a day. However, management anticipates that only about 200,000 liters of liquid waste would be processed in a normal workday. The company operates 300 days per year. The initial investment in the system would be $360,000, and annual operating costs are predicted to be $150,000. The system has a predicted useful life of twelve years and a salvage value of $40,000.

Answer 1

Part (a)

Calculation of savings of surcharge for the year if proposed system is installed:

Surcharge per day = (200,000 litres/1000 litres * $ 4) = $ 800 per day

Cost for the year = $ 800 * 300 days = $ 240,000

Annual operating cost if the new system is installed =$ 150,000

Thus, Net savings from the installation of new system = 240,000 - 150,000

= $ 90,000

Calculation of NPV from the proposed system

	Year	Amount	PVF @ 26%	Present Value
Initial Cost	0	-360,000	1	-360,000
Net savings	1-12	90,000	3.6059	324,531
Salvage Value	12	40,000	0.0625	2,500
NPV				-32969

Project's NPV is -$ 32,969.

Part (b)

IRR would be the discounting rate at which NPV = 0

Solving for IRR using scientific/financial calculator

CF₀ = - 360,000

CF_1-11 = 90,000

CF₁₂ = 130,000

IRR: CPT = 23.1584%

Note: The same can also be done using trial & error method. The answer would still be the same

Part (c)

Payback period refers to the length of time required for an investment to recover its initial outlay in terms of profits or savings.

In the given case, the NPV of the proposed system is negative, i.e. the project is unable to recover it's initial outlay. Hence, the project will not have a payback period. This means that the company will not be able to recover it's initial outlay at a discounting rate of 26%.