Please help me, you must show your work so that I undestand! Lets say you are th

Question

Please help me, you must show your work so that I undestand!

Lets say you are thinking about purchasing new computing system with networking, for your sales force for $112,000. The system will have a 6-year useful life and no salvage value. Now your sales force is expected to generate an additional $37,000 of net income before taxes and depreciation each year by using this upgraded system. The combined federal and state income tax rate = 40%. Annual inflation = 4%.

1) Fill in the following table assuming MACRS depreciation rates:

Now there is the tricky question:

2) If your MARR = 15%, should you purchase this system based on your real after-tax income? Why or why not?

Explanation / Answer

Solution 1)

5-year MACRS Rates : 20%, 32%, 19.20%, 11.52%, 11.52% and 5.76%

Table is filled below:

Solution 2

Some confusion has been created in the question using the words, "should you purchase this system based on your real after-tax income?" We know that the Net Present Value is always calculated using project cash flows and not the after tax income. Therefore, I've solved the question using both approaches, i.e. one with "real after tax income" and the other with "cash flows".

Further calculation is done assuming that the project evaluation has to be made on the basis of real after-tax income and not the free cash flows generated by the project.

Inflation adjusted MARR = ((1 + MARR) / (1 + Rate of Inflation)) 1

= (1.15 / 1.04) 1

= 1.1058 1

= 0.1058 or 10.58%

Based on real after tax income, the purchase should not be done due to a negative NPV. Answer might be different is project evaluation is done using free cash flows generated by purchase.

.

Below is NPV calculation based on cash flows generated by project:

Purchase can be done if cash flows of the project are analyzed because NPV is positive here. I personally feel that the second approach is more logical.

Year Pretax Income Depreciation (Using MACRS 5 years) Taxable Income Tax Owed After Tax Income Inflation adjustment factor Real after tax income 1 $                     37,000.00 $                                                    22,400.00 $                                    14,600.00 $    5,840.00 $               8,760.00 0.96154 $                        8,423.08 2 $                     37,000.00 $                                                    35,840.00 $                                      1,160.00 $        464.00 $                  696.00 0.92456 $                           643.49 3 $                     37,000.00 $                                                    21,504.00 $                                    15,496.00 $    6,198.40 $               9,297.60 0.88900 $                        8,265.53 4 $                     37,000.00 $                                                    12,902.40 $                                    24,097.60 $    9,639.04 $            14,458.56 0.85480 $                     12,359.24 5 $                     37,000.00 $                                                    12,902.40 $                                    24,097.60 $    9,639.04 $            14,458.56 0.82193 $                     11,883.88 6 $                     37,000.00 $                                                      6,451.20 $                                    30,548.80 $ 12,219.52 $            18,329.28 0.79031 $                     14,485.90

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