John is the president of IEEE Harvard. IEEE Harvard is considering to buy a new

Question

John is the president of IEEE Harvard. IEEE Harvard is considering to buy a new a computer system (server, printers, multimedia devices etc.) as a revenue source for the student club. It is projected that this computer system will bring revenues of 20.000 TL per year to IEEE, over the next five years. Annual operating and maintenance expenses of the system are expected to be 5000 TL. The system will have no market value at the end of these five years. The system is depreciated by the SL method. The IEEE’s effective income tax rate is 40% and the after-tax MARR is 10% per year. a) What is the maximum amount that John will be willing to pay for this computer system? b) Even though John depreciated the computer system assuming 0 market value, IEEE was able to sell the computer system for 10.000 TL and the end of year five. How this changes your answer in part (a)?

Explanation / Answer

We have Depreciation Value in terms of Cost of Computer System C

Depreciation Value = (C-Salvage Value)/ 5= C/5 ; We have Salvage Value= 0

Each year John have Net Revenue before Tax = Annual Revenue - Annual Cost - Depreciation Value

= 20000-5000-C/5

Net Revenue after Tax =(15000-C/5)*(1-0.4)=9000-0.12C

This we will have each year hence discounting other cash flows with given MARR=10%

(9000-0.12C)(1/1.1+(1/1.1)^2+(1/1.1)^3+(1/1.1)^4+(1/1.1)^5)=3.79(9000-0.12C)

This should be equal to C to breakeven which ultimately tells us maximum amount than John will be WTP

C=34200-0.456C

1.456C=34200

C= 23432

This is WTP of 23432 TL for the system when salvage value is 0

Answer for B)

Now Salvage Value is 10000 TL

Depreciation Value = (C-10000)/5

Each year John have Net Revenue before Tax = Annual Revenue - Annual Cost - Depreciation Value

= 20000-5000-(C-10000)/5=13000-C/5

Net Revenue after Tax = (13000-C/5)*0.6=7800-0.12C

Present Value of Net Revenune stream = (7800-0.12C)(1/1.1+(1/1.1)^2+(1/1.1)^3+(1/1.1)^4+(1/1.1)^5)=(7800-0.12C)*3.79=29562-0.456C

C=29562-0.456C

1.456C=29562

C=29562/1.456

C=20303

This is WTP of 20303 TL for the system when salvage value is 10000

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