Your firm is contemplating the purchase of a new $666,000 computer-based order e
ID: 2740813 • Letter: Y
Question
Your firm is contemplating the purchase of a new $666,000 computer-based order entry system. The system will be depreciated straight-line to zero over its 5-year life. It will be worth $64,800 at the end of that time. You will be able to reduce working capital by $90,000 (this is a one-time reduction). The tax rate is 32 percent and your required return on the project is 22 percent and your pretax cost savings are $302,300 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 $666,000 computer-based order entry system. The system will be depreciated straight-line to zero over its 5-year life. It will be worth $64,800 at the end of that time. You will be able to reduce working capital by $90,000 (this is a one-time reduction). The tax rate is 32 percent and your required return on the project is 22 percent and your pretax cost savings are $302,300 per year.
Explanation / Answer
Req 1)
Depreciation = $666000 /5 = $133200
Annual Cash Flow = Pre-tax savings 302300 - Dep.133200 = 169100 - tax $54112 = $114988 + Non-cash expense $133200 = $248188
NPV = $248188 * PVIFA(22%,5) + $64800 * PVIF(22%,5) - [666000 - Working capital saving 90000]
= $248188 * 2.8636 + $64800 * 0.37 - 576000 = $158687 , We accept the project.
Req 2)
Annual Cash Flow = Pre-tax savings 217650 - Dep.133200 = 84450 - tax $27024 = $57426 + Non-cash expense $133200 = $190626
NPV = $190626 * PVIFA(22%,5) + $64800 * PVIF(22%,5) - [666000 - Working capital saving 90000]
= $190626 * 2.8636 + $64800 * 0.37 - 576000 = -$6147, we will reject the project.
Req 3)
Indifferent at the saving = 217650 + [6147 * 1/PVIFA(22%,5) * 1/(1-0.32) ]
= 217650 + [6147 * 1/2.8636 * 1/0.68 ] = $220807
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