Your firm is contemplating the purchase of a new $590,000 computer-based order e

Question

Your firm is contemplating the purchase of a new $590,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $62,000 at the end of that time. You will be able to reduce working capital by $77,000 (this is a one-time reduction). The tax rate is 34 percent and the required return on the project is 14 percent. If the pretax cost savings are $202,000 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))

NPV $_______

Will you accept or reject the project?_________

If the pretax cost savings are $152,000 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))

NPV $_________

Will you accept or reject the project?___________

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))

Cost savings $_________

Explanation / Answer

Annual depreciation = initial investment / no of years = 590,000 / 5 = 118,000

Year 0 cashflow = -590,000 + 77,000 = -513,000

Cashflow in years 1-4 = 202,000 * (1-34%) + 118,000 * 34% = 173,440

Cashflow in year 5 = 173,440 + 62,000 * (1-34%) - 77,000 = 137,360

NPV = -513,000 + 173,440 / (1+14%)^1 + 173,440 / (1+14%)^2 + 173,440 / (1+14%)^3 + 173,440 / (1+14%)^4 + 137,360 / (1+14%)^5 = 63,694.74

As NPV is positive, we should accept the project.

Answer: NPV = $ 63,694.74. We should accept the project.

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If Pretax cost saving = 152,000

Year 0 cashflow = -590,000 + 77,000 = -513,000

Cashflow in years 1-4 = 152,000 * (1-34%) + 118,000 * 34% = 140,440

Cashflow in year 5 = 140,440 + 62,000 * (1-34%) - 77,000 = 104,360

NPV = -513,000 + 140,440 / (1+14%)^1 + 140,440 / (1+14%)^2 + 140,440 / (1+14%)^3 + 140,440 / (1+14%)^4 + 104,360 / (1+14%)^5 = -49,596.93, i.e. negative 49,596.93

As NPV is negative, we should reject the project.

Answer: NPV = -49,596.93. We should reject the project.

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If NPV = 0

Let pretax cost saving be X

Then annual cashflow in year 1-4 = X * (1-34%) + 118,000 * 34% = 0.66 * X + 40,120

Cashflow in year 5 = 0.66 * X + 40,120 + 62,000 * (1-34%) - 77,000 = 0.66 * X + 4,040

NPV = -513,000 + (0.66 * X + 40,120) / (1+14%)^1 + (0.66 * X + 40,120) / (1+14%)^2 + (0.66 * X + 40,120) / (1+14%)^3 + (0.66 * X + 40,120) / (1+14%)^4 + (0.66 * X + 4,040) / (1+14%)^5 = 0

Solving for X, we get X = pre tax cost saving = 173,889.05

Answer: Pre tax cost saving = $ 173,889.05

Hope this helped ! Let me know in case of any queries.

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