Spirit software company that generated $12 million in pec-tax operating income o

Question

Spirit software company that generated $12 million in pec-tax operating income on $100 million in revenoes last year the form is stable ans does not expect revenue or operating income to change over the next 10 years it is inventory management is in shambles and inventory as a percent of revenue amounted to 12% last year. Spirit is considering investing in anew inventory management system which will cost 15$ million The inventory management system is expected to have 10 year life cover which period it can be deprecated straight line down to a salvage value of zero. The new invernory managment system is expected to have two benefits it will immediately reduce the inventory maintained of items that are least sold and lower the inventory/sales ratio tp 8%(and stay at that percentage level for the life of the inventory management system) By providing salespeople with updates information on what is in stock, it is expected to increase revenues to $15 million next year(and operating margins to remain unchanged) The revnues and operating income from year 2 to year 10 will remain unchanged at year I levels The redoctions inventory will also allow the company to sell off its existing storage facility(which has a book value of $5 million) today for $10 million and buy a new storage facility for $5 millions Both the old and the new storage facilities will be depeciated straight line over the next 10 years to a salvage value of zero The firm has an income tax of 40% capital gains tax rate of 20% and cost of capital of 10% Estimate the cash flows at time O(today) from this investment ? Estimate the NPV of investing in the new inventory management system ?

Explanation / Answer

Details Amount Initial Cost of Inventory Mangement System 150,00,000.00 Less Net cash flow from Sale of storage -40,00,000.00 A 110,00,000.00 Savings in carrying cost inventory       2,80,000.00 Increase in Operating Margin after Tax     10,80,000.00 Annual incremental cash flow     13,60,000.00 Depreciation tax shield of Inventory management system       6,00,000.00 Net cash flow     19,60,000.00 PVAF for 10% for 10 year 6.144567106 Present value of cash inflows                                 B 120,43,351.53 NPV     10,43,351.53 Workings 1 Average Inventory   12% of Revenue                       120,00,000.00 Average Inventory after Inventory managemt system in Place 8% of increased revenue                         92,00,000.00 Reduction in Average inventory                         28,00,000.00 Inentory carrrying cost 10% PA (Cost of captal Assumed) Savings in Inventory carrying cost                           2,80,000.00 Workings 2 Increase in revenue                       150,00,000.00 Operating Margin                                          0.12 Operating Profit                         18,00,000.00 Tax on Above                                          0.40 Operating profit after tax                         10,80,000.00 Workings 3 Savings in storage cost Sale value of Old storage                       100,00,000.00 Book Valu                         50,00,000.00 Capital Gain                         50,00,000.00 Tax on Above 20%                         10,00,000.00 Cash inflow                         90,00,000.00 Less purchase of new storage                         50,00,000.00 Net Cash inflow                         40,00,000.00 Workings 4 Depreciation Impact Depreciation Tax shield of Inventory Management system 15000000/10*.40                           6,00,000.00 Depreciation Tax impact of storage facility Old storage Book value                         50,00,000.00 New Storage Book Value                         50,00,000.00 Impact                                              -

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