X Firm is considering investing in a complete small business computer system. Th

Question

X Firm is considering investing in a complete small business computer system. The initial investment will be $50,000. The computer is in the 5-year MACRS category, and the firm's tax rate is 34%. The computer system is expected to provide additional revenue of $32,000 per year for the next six years, and to reduce expenses by $7,000 per year for the same period.

a) Calculate the net after-tax cash flows from this investment.
b) Calculate the net present value of the system, given that the law firm's weighted average cost of capital is 12%.
c) Should they buy the computer system?

Explanation / Answer

The MACRS schedule fixes the depreciation rate for computers at 200%. The MACRS schedule & corresponding depreciation amount ($) is as follows:

(MACRS schedule Source: http://seattlecentral.edu/faculty/moneil/Lectures/macrs.htm)

(a) Annual Net after-tax cash flows = [(Additional Revenue + Reduction of Expenses - Depreciation) x (1 - tax rate)] + Depreciation

(Since depreciation is a non-cash item, it is added back to compute net cash flows.

The calculations follow (Values in $):

(b) NPV is the sum of all discounted cash inflows & outflows. The NPV calculations are as follows:

So, NPV = $68,375

(c) Since NPV is positive, they should buy the computer system.

Year Depreciation % Depreciation Amount 1 20 10000 2 32 16000 3 19.2 9600 4 11.52 5760 5 11.52 5760 6 5.76 2880

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