Scott Investors, Inc., is considering the purchase of a $379,000 computer with a

Question

Scott Investors, Inc., is considering the purchase of a $379,000 computer with an economic life of four years. The computer will be fully depreciated over four years using the straight-line method. The market value of the computer will be $79,000 in four years. The computer will replace 4 office employees whose combined annual salaries are $124,000. The machine will also immediately lower the firm’s required net working capital by $99,000. This amount of net working capital will need to be replaced once the machine is sold. The corporate tax rate is 40 percent. The appropriate discount rate is 14 percent. Calculate the NPV of this project.

Explanation / Answer

The market value of the computer will be $79,000 in four years$79,000

Tax on sale -31,600(79000*40%)

After tax salvage value $47,400 (79000-31600)

Next, we will calculate the initial cash outlay, that is, the cash flow at Time 0. To undertake the project, we will have to purchase the equipment.

The new project will decrease the net working capital, so this is a cash inflow at the beginning of the project. So, the cash outlay today for the project will be:

Equipment -$379,000

NWC $99,000

Total -$280,000

Now we can calculate the operating cash flow each year for the project. Using the bottom up approach, the operating cash flow will be:

Saved salaries $124,000

Depreciation $75,800 (379000/5)

EBT $48,200

Taxes 40 % $19280

Net income $28,920

And the OCF will be: OCF = $28,920 + $75,800 = $104,720

Now we can find the NPV of the project. In Year 5, we must replace the saved NWC, so:

NPV = -$280,000 + $104,720(PVIFA l4% for 5 years is 3.433 ) + ($47,400 - $99,000)(PVIFA l4% for 5thyear is 0.543 )

NPV=-$280000+$104720*3.433-$51600*0.543

NPV=-$280000+$314160-$28019

NPV=-$6141

here NPV is negetive so project of machine is not acceptable

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