Your firm is contemplating the purchase of a new $530,000 computer-based order e
ID: 2642594 • Letter: Y
Question
Your firm is contemplating the purchase of a new $530,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $50,000 at the end of that time. You will be able to reduce working capital by $65,000 (this is a one-time reduction). The tax rate is 34 percent and the required return on the project is 14 percent
If the pretax cost savings are $220,000 per year, what is the NPV of this project?
If the pretax cost savings are $150,000 per year, what is the NPV of this project?
At what level of pretax cost savings would you be indifferent between accepting the project and not accepting it?
Explanation / Answer
NPV CALCULATION all amts in $ Situation 1 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Investment in new system (530,000) Reduction of working capital 65,000 Pretax cost saving/incremental revenue 220,000 220,000 220,000 220,000 220,000 Depreciation (106,000) (106,000) (106,000) (106,000) (106,000) Salvage value 50,000 Taxable incremental Income 114,000 114,000 114,000 114,000 164,000 Tax @34% 38,760 38,760 38,760 38,760 55,760 Post Tax Incremental Income 75,240 75,240 75,240 75,240 108,240 Add back depreciation 106,000 106,000 106,000 106,000 106,000 Total incremental opearting cash flow 181,240 181,240 181,240 181,240 214,240 Discount factor @14% 1 0.8772 0.7695 0.6750 0.5921 0.5194 PV of incremental cash flow (465,000) 158,982 139,458 122,332 107,309 111,270 NPV = $ 174,350.76 Situation 2 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Investment in new system (530,000) Reduction of working capital 65,000 Pretax cost saving/incremental revenue 150,000 150,000 150,000 150,000 150,000 Depreciation (106,000) (106,000) (106,000) (106,000) (106,000) Salvage value 50,000 Taxable incremental Income 44,000 44,000 44,000 44,000 94,000 Tax @34% 14,960 14,960 14,960 14,960 31,960 Post Tax Incremental Income 29,040 29,040 29,040 29,040 62,040 Add back depreciation 106,000 106,000 106,000 106,000 106,000 Total incremental opearting cash flow 135,040 135,040 135,040 135,040 168,040 Discount factor @14% 1 0.8772 0.7695 0.6750 0.5921 0.5194 PV of incremental cash flow (465,000) 118,456 103,909 91,148 79,955 87,275 NPV = $ 15,742.42 Indifferent level of pretax cost saving Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Investment in new system (530,000) Reduction of working capital 65,000 Pretax cost saving/incremental revenue 143,052 143,052 143,052 143,052 143,052 Depreciation (106,000) (106,000) (106,000) (106,000) (106,000) Salvage value 50,000 Taxable incremental Income 37,052 37,052 37,052 37,052 87,052 Tax @34% 12,598 12,598 12,598 12,598 29,598 Post Tax Incremental Income 24,454 24,454 24,454 24,454 57,454 Add back depreciation 106,000 106,000 106,000 106,000 106,000 Total incremental opearting cash flow 130,454 130,454 130,454 130,454 163,454 Discount factor @14% 1 0.8772 0.7695 0.6750 0.5921 0.5194 PV of incremental cash flow (465,000) 114,434 100,380 88,053 77,239 84,893 NPV = $ (0.59) so at around pretax opearting cost saving of $143,052 per year , the NPV will be 0. So indifferent level of pretax opearting cost saving is $ 143,052
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