A firm is considering purchasing a computer system. The following data has been

Question

A firm is considering purchasing a computer system. The following data has been collected: Cost of system is $120,000. The firm will pay for the computer system in year 0. Project life: 6 years Salvage value in year-0 (constant) dollars: $15,000 Depreciation method: five-year MACRS Marginal income-tax rate = 40% (remains constant over time) Annual revenue = $145,000 (year-0 constant dollars) Annual expense (not including depreciation) = $82,000 (year-0 constant dollars) If the general inflation rate is 5% during the project period (which will affect all revenues, expenses, and the salvage value but not depreciation), determine the cash flows in actual dollars. Now assume the firm will borrow the entire $120,000 at 9% interest to be repaid in 2 annual payments. The debt interest paid and the principal repayment should not be changed by the inflation rate. Lending agencies set the interest rate of borrowing to account for the inflation rate. Calculate the effects of borrowing and include the debt interest paid and the principal repayment into the income statement and cash flow statement. Do this exactly as you did in Chapter 10, but leave the other elements (eg. annual revenue, annual expense, depreciation, salvage value) unchanged from part (a). Determine the cash flows in actual dollars with borrowing. The inflation-free interest rate is 13%. Use the inflation-free interest rate and the average general inflation rate to calculate the market interest rate. Compute the present worth of the cash flow from part using the market interest rate. Based on the present worth calculation, should the firm purchase the computer system

Explanation / Answer

Cost of system 120000 Life 6 yrs salvage value 15000 After tax salvage value 9000 Dep 5 yrs MACRS Dep rate 20% 32% 19.20% 11.52% 11.52% 5.76% a) year 1 2 3 4 5 6 Revenue 145000 152250 159862.5 167855.625 176248.4063 185060.8266 Expenses 82000 86100 90405 94925.25 99671.5125 104655.0881 contribution 63000 66150 69457.5 72930.375 76576.89375 80405.73844 Less: depreciation 24000 38400 23040 13824 13824 6912 Net profit 39000 27750 46417.5 59106.375 62752.89375 73493.73844 Tax 15600 11100 18567 23642.55 25101.1575 29397.49538 PAT 23400 16650 27850.5 35463.825 37651.73625 44096.24306 Add: dep 24000 38400 23040 13824 13824 6912 Cashflow 47400 55050 50890.5 49287.825 51475.73625 51008.24306 After tax salvage value 9000 Total cashflow 47400 55050 50890.5 49287.825 51475.73625 60008.24306 b) year 0 1 2 3 4 5 6 Revenue 145000 152250 159862.5 167855.625 176248.4063 185060.8266 Expenses 82000 86100 90405 94925.25 99671.5125 104655.0881 contribution 63000 66150 69457.5 72930.375 76576.89375 80405.73844 Less: depreciation 24000 38400 23040 13824 13824 6912 Interest 10800 10800 Net profit 28200 16950 46417.5 59106.375 62752.89375 73493.73844 Tax 11280 6780 18567 23642.55 25101.1575 29397.49538 PAT 16920 10170 27850.5 35463.825 37651.73625 44096.24306 Add: dep 24000 38400 23040 13824 13824 6912 Cashflow 40920 48570 50890.5 49287.825 51475.73625 51008.24306 After tax salvage value 47400 Cashflow 40920 48570 50890.5 49287.825 51475.73625 98408.24306 Loan 120000 -70800 -70800 Net cashflow 120000 -29880 -22230 50890.5 49287.825 51475.73625 98408.24306 c) year 1 2 3 4 5 6 Revenue 145000 152250 159862.5 167855.625 176248.4063 185060.8266 Expenses 82000 86100 90405 94925.25 99671.5125 104655.0881 contribution 63000 66150 69457.5 72930.375 76576.89375 80405.73844 Less: depreciation 24000 38400 23040 13824 13824 6912 Net profit 39000 27750 46417.5 59106.375 62752.89375 73493.73844 Tax 15600 11100 18567 23642.55 25101.1575 29397.49538 PAT 23400 16650 27850.5 35463.825 37651.73625 44096.24306 Add: dep 24000 38400 23040 13824 13824 6912 Cashflow 47400 55050 50890.5 49287.825 51475.73625 51008.24306 After tax salvage value 120000 Total cashflow 47400 55050 50890.5 49287.825 51475.73625 171008.2431 PVIF(13%) 0.88495 0.78314 0.69305 0.61331 0.54275 0.48031 PV cashflow 41946.63 43111.857 35269.66103 30228.71595 27938.45585 82136.96923

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