Your firm is contemplating the purchase of a new $565,000 computer-based order e
ID: 2710483 • Letter: Y
Question
Your firm is contemplating the purchase of a new $565,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $57,000 at the end of that time. You will be able to reduce working capital by $72,000 (this is a one-time reduction). The tax rate is 30 percent and the required return on the project is 16 percent. If the pretax cost savings are $213,000 per year, what is the NPV of this project? If the pretax cost savings are $163,000 per year, what is the NPV of this project? At what level of pretax cost savings would you be indifferent between accepting the project and not accepting it?
Explanation / Answer
All amounts in $ Details Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Investment (565,000) Reduction in WC (assume it happens in Year 1) 72,000 Cost Saving or Incremental Revenue pretax 213,000 213,000 213,000 213,000 213,000 Salvage value(taxable) 57,000 Depreciation (113,000) (113,000) (113,000) (113,000) (113,000) Pretax earning 100,000 100,000 100,000 100,000 157,000 Tax @30% 30,000 30,000 30,000 30,000 47,100 Post Tax earning 70,000 70,000 70,000 70,000 109,900 Add back depreciation 113,000 113,000 113,000 113,000 113,000 Post Tax cash flow(including WC reduction) 255,000 183,000 183,000 183,000 222,900 Discount factor @16% 1 0.862 0.743 0.641 0.552 0.476 PV of cash inflow 680,262 219,828 135,999 117,240 101,069 106,126 NPV 115,262 So NPV is $115,262 Situation 2 with pretax cost saving 163000 All amounts in $ Details Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Investment (565,000) Reduction in WC (assume it happens in Year 1) 72,000 Cost Saving or Incremental Revenue pretax 163,000 163,000 163,000 163,000 163,000 Salvage value(taxable) 57,000 Depreciation (113,000) (113,000) (113,000) (113,000) (113,000) Pretax earning 50,000 50,000 50,000 50,000 107,000 Tax @30% 15,000 15,000 15,000 15,000 32,100 Post Tax earning 35,000 35,000 35,000 35,000 74,900 Add back depreciation 113,000 113,000 113,000 113,000 113,000 Post Tax cash flow 220,000 148,000 148,000 148,000 187,900 Discount factor @16% 1 0.862 0.743 0.641 0.552 0.476 PV of cash inflow 565,661 189,655 109,988 94,817 81,739 89,462 NPV 661 So revised NPV $661 Point of Indifference All amounts in $ Details Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Investment (565,000) Reduction in WC (assume it happens in Year 1) 72,000 Cost Saving or Incremental Revenue pretax 162,710 162,710 162,710 162,710 162,710 Salvage value(taxable) 57,000 Depreciation (113,000) (113,000) (113,000) (113,000) (113,000) Pretax earning 49,710 49,710 49,710 49,710 106,710 Tax @30% 14,913 14,913 14,913 14,913 32,013 Post Tax earning 34,797 34,797 34,797 34,797 74,697 Add back depreciation 113,000 113,000 113,000 113,000 113,000 Post Tax cash flow 219,797 147,797 147,797 147,797 187,697 Discount factor @16% 1 0.862 0.743 0.641 0.552 0.476 PV of cash inflow 564,997 189,480 109,837 94,687 81,627 89,365 NPV (3) At pretax cost saviing level of $162,710 per year, the NPV becomes 0. So at pretax cost saving level $ 162,710 I would be indifferent to accept or reject the project.
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