Your firm is contemplating the purchase of a new $570,000 computer-based order e

Question

Your firm is contemplating the purchase of a new $570,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $58,000 at the end of that time. You will be able to reduce working capital by $73,000 (this is a one-time reduction). The tax rate is 35 percent and the required return on the project is 15 percent. If the pretax cost savings are $212,000 per year, what is the NPV of this project? (Do not round intermediate calculations and round your final answer to 2 decimal places, e.g., 32.16.) NPV Will you accept or reject the project? Accept O Reject If the pretax cost savings are $162,000 per year, what is the NPV of this project? (Negative amount should be indicated by a minus sign. Do not round intermediate calculations and round your final answer to 2 decimal places, e.g., 32.16.) NPV Will you accept or reject the project? Accept Reject At what level of pretax cost savings would you be indifferent between accepting the project and not accepting it? (Do not round intermediate calculations and round your final answer to 2 decimal places, e.g., 32.16.) Cost savings

Explanation / Answer

Initial investment = $570000 - 73000 = $497000

Yearly Depreciation = (570000 - 58000) / 5 = $102400

Yearly Benefits = [(pretax cost benefits - depreciation) * (1 - tax)] + depreciation = [(212000 - 102400) * (1 - 0.35)] + 102400 = $173640

Total Benefits = Yearly benefits * PVIFA (15% , 5 years) = $173640 * 3.352 = $582041

Salvage Benefits = Salvage * (1 - tax) *  PVIF (15% , 5 years) = $58000 * 0.65 * 0.497 = $18737

1) NPV = - Initial cash outflow + Total benefits ie. cost + salvage

= - 497000 + 582041 + 18737 = $103778

We should accept the project.

2)

Yearly Benefits = [(pretax cost benefits - depreciation) * (1 - tax)] + depreciation = [(162000 - 102400) * (1 - 0.35)] + 102400 = $141140

Total Benefits = Yearly benefits * PVIFA (15% , 5 years) = $141140 * 3.352 = $473101

NPV = - Initial cash outflow + Total benefits ie. cost + salvage

= - 497000 + 473101 + 18737 = - $5162

We should not accept the project as NPV is negative.

3) Let the cost saving be "x".

- Initial cash outflow + Total benefits ie. cost + salvage = 0

=> - 497000 + { [(x - 102400) * (1 - 0.35)] + 102400 } * 3.352 + 18737 = 0

=> [(0.65x - 66560) + 102400] } * 3.352 = 478263

=> 0.65 x + 35840 = 142680

Thus, x = $164369

At pretax cost saving of $164369, we are indifferent to the acceptance or not acceptance of the project.

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