Background Data COMM Company is considering an investment in a new inventory con

Question

Background Data

COMM Company is considering an investment in a new inventory control system. The system will require a substantial up-front investment but is expected to provide annual cash cost savings for the next 6 years. At the end of that year (year 6) the used system is likely to be outdated (but still functional) and will be sold for an estimated 10% of original cost. (The equipment is sold at the end of year 6) The system falls under the 7 year IRS depreciation guidelines (assume straight line depreciation full year every year). (Congress mandates tax related depreciation guidelines). The system is expected to become operational at a cost of $2,100,000. Annual cash cost savings (primarily due to labor cost savings) are expected to average $500,000. COMM is in the 35% combined federal and state tax bracket and uses a hurdle rate of 10% to evaluate capital projects.

Required

1. Prepare an exhibit that displays the outcome of your capital budgeting model’s NPV related calculations. The exhibit should clearly show each event that has a cash flow impact and the project's Net Present Value (you can use the model we developed in class or set up your own MS Excel model).

2. Is the project’s IRR more or less than the hurdle rate of 10%? How do you know? Within a range of 1 percentage point (for example 6% - 7%) where does the IRR on this project fall?

3. Capital Budgeting models (like all forecasts) are driven primarily by educated assumptions about outcomes. Which actual outcomes are most subject to deviation from expected outcomes? Why?

Explanation / Answer

1. IRS depn. Rate Year Details of cost/savings Amount Tax savings due to depn. Total cash flow PV F @ 10% PV @ 10% 0 Initial cost -2100000 -2100000 1 -2100000 14.29 1 Annual cost savings 500000 105031.5 605031.5 0.9091 550034.1 24.49 2 500000 180001.5 680001.5 0.8264 561953.2 17.49 3 500000 128551.5 628551.5 0.7513 472230.7 12.49 4 500000 91801.5 591801.5 0.683 404200.4 8.93 5 500000 65635.5 565635.5 0.6209 351203.1 8.92 6 500000 65562 565562 0.5645 319259.7 6 Sale proceeds 210000 210000 0.5645 118545 Net Present Value of the Investment 677426.4 NOTE: Tax savings due to depn. 2100000*Yearly IRS rate* 0.35 2. IRR for this project (as per excel function) Rate which equates the PVs of inflows and outflows in the total cash flows column: ie. 2100000= 605031.5/(1+r)^1+680001.5/(1+r)^2+628551.5/(1+r)^3+ 591801.5/(1+r)^4+565635/(1+r)^5+565562/(1+r)^6+21000/(1+r)^6 Solving for r, (using Excel IRR function On ths column), we get                                      IRR for this Investment = 20% which is 10% more than the hurdle rate

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