Your firm is contemplating the purchase of a new $550,000 computer-based order e
ID: 2710482 • Letter: Y
Question
Your firm is contemplating the purchase of a new $550,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $54,000 at the end of that time. You will be able to reduce working capital by $69,000 (this is a one-time reduction). The tax rate is 30 percent and the required return on the project is 16 percent.
If the pretax cost savings are $216,000 per year, what is the NPV of this project? (Do not round intermediate calculations and round your final answer to 2 decimal places, e.g., 32.16.)
If the pretax cost savings are $166,000 per year, what is the NPV of this project? (Negative amount should be indicated by a minus sign. Do not round intermediate calculations and round your final answer to 2 decimal places, e.g., 32.16.)
At what level of pretax cost savings would you be indifferent between accepting the project and not accepting it? (Do not round intermediate calculations and round your final answer to 2 decimal places, e.g., 32.16.)
Your firm is contemplating the purchase of a new $550,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $54,000 at the end of that time. You will be able to reduce working capital by $69,000 (this is a one-time reduction). The tax rate is 30 percent and the required return on the project is 16 percent.
Explanation / Answer
All amounts in $ Details Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Investment (550,000) Reduction in WC (assume it happens in Year 1) 69,000 Cost Saving or Incremental Revenue pretax 216,000 216,000 216,000 216,000 216,000 Salvage value(taxable) 54,000 Depreciation (110,000) (110,000) (110,000) (110,000) (110,000) Pretax earning 106,000 106,000 106,000 106,000 160,000 Tax @30% 31,800 31,800 31,800 31,800 48,000 Post Tax earning 74,200 74,200 74,200 74,200 112,000 Add back depreciation 110,000 110,000 110,000 110,000 110,000 Post Tax cash flow(including WC reduction) 253,200 184,200 184,200 184,200 222,000 Discount factor @16% 1 0.862 0.743 0.641 0.552 0.476 PV of cash inflow 680,605 218,276 136,891 118,009 101,732 105,697 NPV 130,605 So NPV is $130,605 As NPV is positive I shall accept the project Situation 2 with pretax cost saving 166000 All amounts in $ Details Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Investment (565,000) Reduction in WC (assume it happens in Year 1) 69,000 Cost Saving or Incremental Revenue pretax 166,000 166,000 166,000 166,000 166,000 Salvage value(taxable) 54,000 Depreciation (113,000) (110,000) (110,000) (110,000) (110,000) Pretax earning 53,000 56,000 56,000 56,000 110,000 Tax @30% 15,900 16,800 16,800 16,800 33,000 Post Tax earning 37,100 39,200 39,200 39,200 77,000 Add back depreciation 113,000 110,000 110,000 110,000 110,000 Post Tax cash flow(including WC reduction) 219,100 149,200 149,200 149,200 187,000 Discount factor @16% 1 0.862 0.743 0.641 0.552 0.476 PV of cash inflow 566,780 188,879 110,880 95,586 82,402 89,033 NPV 1,780 So revised NPV $1780 Point of Indifference All amounts in $ Details Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Investment (565,000) Reduction in WC (assume it happens in Year 1) 69,000 Cost Saving or Incremental Revenue pretax 165,225 165,225 165,225 165,225 165,225 Salvage value(taxable) 54,000 Depreciation (113,000) (110,000) (110,000) (110,000) (110,000) Pretax earning 52,225 55,225 55,225 55,225 109,225 Tax @30% 15,668 16,568 16,568 16,568 32,768 Post Tax earning 36,558 38,658 38,658 38,658 76,458 Add back depreciation 113,000 110,000 110,000 110,000 110,000 Post Tax cash flow(including WC reduction) 218,558 148,658 148,658 148,658 186,458 Discount factor @16% 1 0.862 0.743 0.641 0.552 0.476 PV of cash inflow 565,004 188,412 110,477 95,239 82,102 88,775 NPV 4 At pretax cost saviing level of $165,225 per year, the NPV becomesapprox 0. So at pretax cost saving level $ 165,225 I would be indifferent to accept or reject the project.
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