Your firm is contemplating the purchase of a new $666,000 computer-based order e
ID: 2740760 • Letter: Y
Question
Your firm is contemplating the purchase of a new $666,000 computer-based order entry system. The system will be depreciated straight-line to zero over its 5-year life. It will be worth $64,800 at the end of that time. You will be able to reduce working capital by $90,000 (this is a one-time reduction). The tax rate is 32 percent and your required return on the project is 22 percent and your pretax cost savings are $302,300 per year.
At what level of pretax cost savings would you be indifferent between accepting the project and not accepting it?
Your firm is contemplating the purchase of a new $666,000 computer-based order entry system. The system will be depreciated straight-line to zero over its 5-year life. It will be worth $64,800 at the end of that time. You will be able to reduce working capital by $90,000 (this is a one-time reduction). The tax rate is 32 percent and your required return on the project is 22 percent and your pretax cost savings are $302,300 per year.
Explanation / Answer
Ans1 Calculation of cash flow Particular 0 1 2 3 4 5 Initial investment -666000 Working Capital -90000 Cost saving 302300 302300 302300 302300 302300 Less: Tax @32% 96736 96736 96736 96736 96736 Net saving 205564 205564 205564 205564 205564 Add tax save on dep 38477 38477 38477 38477 38477 Add: Selvage value 64800 less: Tax paid on selvage -20736 Add: reduction in working capital 90000 Net cash flow -756000 643077 643077 643077 643077 777141 Calculation of depreciation (666000-64800)/5 120240 Tax save on depreciation 120240*32% 38477 Tax paid on selvage value 64800*32%= 20736 Calculation of NPV year Cash flow PVAF 22% Net cash flow 0 -756000 1 -756000 1 643077 0.8197 527112.3 2 643077 0.6719 432059.3 3 643077 0.5507 354146.9 4 643077 0.4514 290284.4 5 777141 0.3700 287541.6 NPV 1135144 Case 2 Calculation of cash flow Particular 0 1 2 3 4 5 Initial investment -666000 Working Capital -90000 Cost saving 217650 217650 217650 217650 217650 Less: Tax @32% 69648 69648 69648 69648 69648 Net saving 148002 148002 148002 148002 148002 Add tax save on dep 38477 38477 38477 38477 38477 Add: Selvage value 64800 less: Tax paid on selvage -20736 Add: reduction in working capital 90000 Net cash flow -756000 473777 473777 473777 473777 607841 Calculation of NPV year Cash flow PVAF 22% Net cash flow 0 -756000 1 -756000 1 473777 0.8197 388341.8 2 473777 0.6719 318313 3 473777 0.5507 260912.3 4 473777 0.4514 213862.5 5 473777 0.3700 175297.1 NPV 600726.7 Ans3: Where NPV shall be zero then it shall be break even point
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