Your firm is contemplating the purchase of a new $540,000 computer-based order e

Question

Your firm is contemplating the purchase of a new $540,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $52,000 at the end of that time. You will be able to reduce working capital by $67,000 (this is a one-time reduction). The tax rate is 35 percent and the required return on the project is 15 percent.

If the pretax cost savings are $218,000 per year, what is the NPV of this project? (Do not round intermediate calculations and round your final answer to 2 decimal places, e.g., 32.16.)

If the pretax cost savings are $155,000 per year, what is the NPV of this project? (Negative amount should be indicated by a minus sign. Do not round intermediate calculations and round your final answer to 2 decimal places, e.g., 32.16.)

At what level of pretax cost savings would you be indifferent between accepting the project and not accepting it? (Do not round intermediate calculations and round your final answer to 2 decimal places, e.g., 32.16.)

Your firm is contemplating the purchase of a new $540,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $52,000 at the end of that time. You will be able to reduce working capital by $67,000 (this is a one-time reduction). The tax rate is 35 percent and the required return on the project is 15 percent.

Explanation / Answer

a. NPV of the project at 15% reqd. return= PV Factor at 15% PVOA factor,15% PV at 15% Reqd. return Initial investment Year 0) -540000 1 -540000 Initial NWC saved 67000 1 67000 Yr 1-Yr.5 annual cash from operations: After-tax cost savings(218000*(1-35%)) 141700 Add :Annual depn.Tax shield(540000-0)/5*35% 37800 Annual OCF 179500 3.35216 601711.84 After-tax salvage in Yr.5(52000*(1-35%)) 33800 0.497177 16804.57 Restoration of original NWC level in Yr. 5 -67000 0.497177 -33310.84 NPV of the project at 15% reqd. return= 112205.57 As NPV is positive the project can be ACCEPTED b. NPV of the project at 15% reqd. return= PV Factor at 15% PVOA factor,15% PV at 15% Reqd. return Initial investment Year 0) -540000 1 -540000 Initial NWC saved 67000 1 67000 Yr 1-Yr.5 annual cash from operations: After-tax cost savings(155000*(1-35%)) 100750 Add :Annual depn.Tax shield(540000-0)/5*35% 37800 Annual OCF 138550 3.35216 464441.09 After-tax salvage in Yr.5(52000*(1-35%)) 33800 0.497177 16804.57 Restoration of original NWC level in Yr. 5 -67000 0.497177 -33310.84 NPV of the project at 15% reqd. return= -25065.18 As NPV is NEGATIVE the project should be REJECTED c. Indifference between accepting the project and not accepting it For indifference in cost savings , NPV should be equal to 0(neither -ve nor +ve) So, Supposing that level of cost savings to be x , then, NPV= -540000+67000+((x*(1-35%))+37800)*3.35216)+16804.57-33310.84=0 Solving the above equation, we get , x=Cost savings= 166503

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