Your firm is contemplating the purchase of a new $1,258,000 computer-based order
ID: 2757698 • Letter: Y
Question
Your firm is contemplating the purchase of a new $1,258,000 computer-based order entry system. The system will be depreciated straight-line to zero over its 5-year life. It will be worth $122,400 at the end of that time. You will be able to reduce working capital by $170,000 (this is a one-time reduction). The tax rate is 35 percent and your required return on the project is 19 percent and your pretax cost savings are $387,900 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 $1,258,000 computer-based order entry system. The system will be depreciated straight-line to zero over its 5-year life. It will be worth $122,400 at the end of that time. You will be able to reduce working capital by $170,000 (this is a one-time reduction). The tax rate is 35 percent and your required return on the project is 19 percent and your pretax cost savings are $387,900 per year.
Explanation / Answer
Part A
Annual Depreciation = (1258000-0)/ 5 = 251,600
Depreciation tax shield = 251,600 x 35%
= 88,060
Annual cash flow = after tax cost savings + depreciation tax shield
= 387,900 x (1-0.35) + 88,060
= 340,195
After tax salvage value = salvage value x (1- t)
= 122400 x (1-0.35)
= 79,560
Total initial investment = 1258000 -170,000
= 1088000
Year
Cash flow
PV factor 19%
PV
0
-1088000
1
-1088000
1
340195
0.840336134
285878.2
2
340195
0.706164819
240233.7
3
340195
0.593415814
201877.1
4
340195
0.498668751
169644.6
5
-170000
0.419049371
-71238.4
5
79560
0.419049371
33339.57
5
340195
0.419049371
142558.5
NPV
-85706.7
NPV =-85706.70
Part b
Annual cash flow = after tax cost savings + depreciation tax shield
= 538,800 x (1-0.35) + 88,060
= 438280
Year
Cash flow
PV factor 19%
PV
0
-1088000
1
-1088000
1
438280
0.840336134
368302.5
2
438280
0.706164819
309497.9
3
438280
0.593415814
260082.3
4
438280
0.498668751
218556.5
5
-170000
0.419049371
-71238.4
5
79560
0.419049371
33339.57
5
438280
0.419049371
183661
NPV
214201.4
NPV = 214201.40
Year
Cash flow
PV factor 19%
PV
0
-1088000
1
-1088000
1
340195
0.840336134
285878.2
2
340195
0.706164819
240233.7
3
340195
0.593415814
201877.1
4
340195
0.498668751
169644.6
5
-170000
0.419049371
-71238.4
5
79560
0.419049371
33339.57
5
340195
0.419049371
142558.5
NPV
-85706.7
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