Your firm is contemplating the purchase of a new $555,000 computer-based order e

Question

Your firm is contemplating the purchase of a new $555,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $55,000 at the end of that time. You will be able to reduce working capital by $70,000 (this is a one-time reduction). The tax rate is 35 percent and the required return on the project is 15 percent.

A-1   If the pretax cost savings are $215,000 per year, what is the NPV of this project?

A--2 Will you accept or reject the project?

B-1 If the pretax cost savings are $165,000 per year, what is the NPV of this project?

B-2 Will you accept or reject the project?

Explanation / Answer

Your firm is contemplating the purchase of a new $850,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $150,000 at the end of that time. You will save $350,000 before taxes per year in order processing costs and you will be able to reduce working capital by $125,000 (this is a one-time reduction). If the tax rate is 35%, what is the IRR for this project?Isuppose your required return on the project s 20% and your pretax cost savings are only $300,000 per year. Will you accept the project? At what level of pretax cost savings would you be indifferent between accepting the project and not accepting it (NPV = 0).

solution:

Depr = 555,000/5 = 111,000

Gross profit 70,000                OCF = 180,000 + 170,000

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