Your firm is contemplating the purchase of a new $1,036,000 computer-based order

Question

Your firm is contemplating the purchase of a new $1,036,000 computer-based order entry system. The system will be depreciated straight-line to zero over its 5-year life. It will be worth $100,800 at the end of that time. You will be able to reduce working capital by $140,000 (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 $470,250 per year. 1.)What is the NPV of this project? 2.)What is the NPV if the pretax cost savings are $338,600 per year? 3.) At what level of pretax cost savings would you be indifferent between accepting the project and not accepting it?

Explanation / Answer

INITIAL CASH FLOW

PURCHASE PRICE OF NEW EQUIPEMENT = ($1036000)

REDUCTION IN WORKING CAPITAL = $140000

TOTAL CASH FLOW = $896000

INBETWEEN CASH FLOW YEAR 1-5

PRE TAX COST SAVING = $470250

LESS TAX @ 32% = ($150480)

ADD DEPRICIATION = $207200

AFTER TAX CASHFLOW =$526970

TERMINAL CASHFLOW

SALVAGE VALUE = $100800

LESS TAX @32% = ($32256)

AFTER TAX CASH FLOW = $68544

1./

NPV OF THE PROJECT

2./

IF THE PRE TAX COST SAVING ARE $338600

INBETWEEN CASH FLOW YEAR 1-5

PRE TAX COST SAVING = $338600

LESS TAX @ 32% = ($108352)

ADD DEPRICIATION = $207200

AFTER TAX CASHFLOW =$437488

NPV OF THE PROJECT

3./

INDIFFRENCE BETWEEN ACCEPTIN & REJECTING POINT IS NPV = 0

SO LET THE PRE TAX COST SAVING BE "X"

AFTER TAX COST SAVING "X" * (1 - 0.32) + $207200

= 0.68X + $207200

NPV = ($896000) + 2.8636 * (0.68X + $207200) + $68544 * 0.3700

0 = ($896000) + 1.9472X + $593337.92 + $25361.28

1.9472X = $277300.8

X = $277300.8 / 1.9472

X = $142410.02

AT $142410.02 PRETAX COST SAVING IT WOULD BE INDIFFRENT BETWEEN ACCEPTING THE PROJECT AND NOT ACCEPTING THE PROJECT.

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