P10-15 Project Evaluation [LO1] Your firm is contemplating the purchase of a new
ID: 2709104 • Letter: P
Question
P10-15 Project Evaluation [LO1]
Your firm is contemplating the purchase of a new $1,942,500 computer-based order entry system. The system will be depreciated straight-line to zero over its 5-year life. It will be worth $189,000 at the end of that time. You will be able to reduce working capital by $262,500 (this is a one-time reduction). The tax rate is 30 percent and your required return on the project is 23 percent and your pretax cost savings are $891,450 per year.
At what level of pretax cost savings would you be indifferent between accepting the project and not accepting it?
Your firm is contemplating the purchase of a new $1,942,500 computer-based order entry system. The system will be depreciated straight-line to zero over its 5-year life. It will be worth $189,000 at the end of that time. You will be able to reduce working capital by $262,500 (this is a one-time reduction). The tax rate is 30 percent and your required return on the project is 23 percent and your pretax cost savings are $891,450 per year.
Explanation / Answer
Answer: Requirement 1
First we calculate the annual depreciation of the new equipment.It will be:
=$1942500/5=$388500
The after tax salvage value of the equipment is:
After tax salvage value=189000(1-0.30)
=$132300
using the tax shield approach, the OCF is:
OCF=891450 (1-0.30)+388500 (0.30)
OCF=740565
NPV=-$1,942,500 +$262500+740565 (PVIFA23%,5)+[$132300-$262500/(1.23)5]
=-$1680000+2076153.965-46247.19624
=$349906.77
Answer: Requirement 2:
First we calculate the annual depreciation of the new equipment.It will be:
=$1942500/5=$388500
The after tax salvage value of the equipment is:
After tax salvage value=189000(1-0.30)
=$132300
using the tax shield approach, the OCF is:
OCF=641850 (1-0.30)+388500 (0.30)
OCF=565845
NPV=-$1,942,500 +$262500+565845 (PVIFA23%,5)+[$132300-$262500/(1.23)5]
=-$1680000+1586331.17-46247.19624
=-$139916.03
Answer: Requirement 3:
NPV=-$1,942,500 +$262500+x (PVIFA23%,5)+[$132300-$262500/(1.23)5]
0=-1680000+2.8034729 x -46247.19624
x=615753.124005
OCF=615753.124005
OCF=x (1-0.30)+388500 (0.30)
615753.124005=0.70x +116550
x=713147.30
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