Your firm is contemplating the purchase of a new $1,258,000 computer-based order

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?

rev: 09_18_2012

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

Requirement 1 Based on the information given, the Pretax cost savings are $ 387,900 per year Hence, the post tax cost savings will be 65% of $ 387,900 = 252135 $ From this value, and the other information provided, the Net Present Value of the project will be - $ 69,106.14 Since, -$ 81,421.39 is closest to this amount, hence that can be considered to be the correct solution. Requirement 2 If the pre-tax cost savings are $ 538,800 per year, the Net Present Value of the project works out to $ 256,716.26 Since $ 224,911.46 is closest to this amount, hence that can be considered to be the correct solution. Requirement 3 At $ 431,023.69, we would be indifferent between accepting or rejecting the project.

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