Scott Investors, Inc., is considering the purchase of a $360,000 computer with a
ID: 2419145 • Letter: S
Question
Scott Investors, Inc., is considering the purchase of a $360,000 computer with an economic life of five years. The computer will be fully depreciated over five years using the straight-line method. The market value of the computer will be $60,000 in five years. The computer will replace five office employees whose combined annual salaries are $105,000. The machine will also immediately lower the firm’s required net working capital by $80,000. This amount of net working capital will need to be replaced once the machine is sold. The corporate tax rate is 34 percent. The appropriate discount rate is 12 percent.
Calculate the NPV of this project. (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))
Explanation / Answer
(a) Initial cash flow
First, we need to determine the firm’s initial cash flow when it decides to take on the new project. This includes the initial investment in the computer and the “savings” in working capital (due to the computer).
Year 0
Computer
-$360,000
Net working capital
80,000
Total cash flow
-$280,000
(b) Depreciation recovery of computer
Since the computer has a classified life of 5 years, it will be depreciated using the Straight Line method. The following table presents the depreciation value (or recovery value) over its 5-year life (based on the book value of $360,000):
Year
Recovery
1
$72,000
2
72,000
3
72,000
4
72,000
5
72,000
(c) Annual after-tax cash flow
In this particular situation, the annual after-tax operating cash flow is made up of two components: (1) the after-tax savings on wages, and (2) the depreciation tax-shield from the computer.
Year 1
Year 2
Year 3
Year 4
Year 5
After-tax savings on wages
$69,300
$69,300
$69,300
$69,300
$69,300
Depreciation tax shield
24,480
24,480
24,480
24,480
24,480
After-tax cash flow
93,780
93,780
93,780
99,600
99,600
(d) Terminal cash flow
In addition, since the initial working capital will be recaptured by the firm, that will represent cash “outflow” for the firm from the project’s point of view. The terminal cash flow of the project is presented as follows:
Year 5
Sale of computer
$60,000
Tax on computer
-20,400
Recapture of NWC
-80,000
Total terminal cash flow
-$40,400
(e) Annual total after-tax cash flows for the project
Using information from part (a), (c) and (d), we can determine the annual after-tax cash flows generated by the project over its 5-year life as follows:
Year
Amount
0
-$280,000
1
93,780
2
93,780
3
93,780
4
93,780
5
53,780
Using a financial calculator, we know when the cost of capital is 12%, the NPV of this project is
Net Present value (NPV)= -Co+{C1/(1+r)}+{C2/(1+r)^2}+….+{Cr/(1+r)^T}
Co= Initial Cash Flow
C= Cash Flow
r= Discount Rate
T=Time
= -280000+{93780/(1+.12)}+{93780/(1+.12)^2+……+{53780/(1+.12)^5
=58,055.91
Net present value of the Project would be $58,055.91
Year 0
Computer
-$360,000
Net working capital
80,000
Total cash flow
-$280,000
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