Your firm is contemplating the purchase of a new $575,000 computer-based order e
ID: 2777788 • Letter: Y
Question
Your firm is contemplating the purchase of a new $575,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $59,000 at the end of that time. You will be able to reduce working capital by $74,000 (this is a one-time reduction). The tax rate is 34 percent and the required return on the project is 14 percent.
If the pretax cost savings are $211,000 per year, what is the NPV of this project?
If the pretax cost savings are $161,000 per year, what is the NPV of this project?
At what level of pretax cost savings would you be indifferent between accepting the project and not accepting it?
Explanation / Answer
Your firm is contemplating the purchase of a new $575,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $59,000 at the end of that time. You will be able to reduce working capital by $74,000 (this is a one-time reduction). The tax rate is 34 percent and the required return on the project is 14 percent.
If the pretax cost savings are $211,000 per year, what is the NPV of this project?
Initial Investment = Investment in computer-based order entry system. - Reduction in Working Capital
Initial Investment = 575000 - 74000
Initial Investment = $ 501000
Annual Depreciation = 575000/5 = 115000
Annual Cash Flow = pretax cost savings*(1-tax rate) + Annual Depreciation*Tax rate
Annual Cash Flow = 211000*(1-34%) + 115000*34%
Annual Cash Flow = $ 178360
Terminal Value = Post tax salvage value - Working capital
Terminal Value = 59000*(1-34%) - 74000
Terminal Value = - $ 35060
NPV = -Initial Investment + Annual Cash Flow*(1-(1+r)^-n)/r + Terminal Value*(1+r)^-n
NPV = -501000 + 178360*(1-(1+14%)^-5)/14% - 35060*(1+14%)^-5
NPV = $ 93,115.26
If the pretax cost savings are $161,000 per year, what is the NPV of this project?
Initial Investment = Investment in computer-based order entry system. - Reduction in Working Capital
Initial Investment = 575000 - 74000
Initial Investment = $ 501000
Annual Depreciation = 575000/5 = 115000
Annual Cash Flow = pretax cost savings*(1-tax rate) + Annual Depreciation*Tax rate
Annual Cash Flow = 161000*(1-34%) + 115000*34%
Annual Cash Flow = $ 145360
Terminal Value = Post tax salvage value - Working capital
Terminal Value = 59000*(1-34%) - 74000
Terminal Value = - $ 35060
NPV = -Initial Investment + Annual Cash Flow*(1-(1+r)^-n)/r + Terminal Value*(1+r)^-n
NPV = -501000 + 145360*(1-(1+14%)^-5)/14% - 35060*(1+14%)^-5
NPV = - $ 20,176.42
At what level of pretax cost savings would you be indifferent between accepting the project and not accepting it?
Annual cash flow require to break even = (Initial Investment + Terminal Value*(1+r)^-n)/((1-(1+r)^-n)/r )
Annual cash flow require to break even = (501000 + 35060*(1+14%)^-5)/ ((1-(1+14%)^-5)/14%)
Annual cash flow require to break even = $ 151,237.06
Pretax cost savings = (Annual cash flow require to break even - Annual Depreciation*Tax rate)/(1-tax rate)
Pretax cost savings = (151237.06 - 115000*34%)/(1-34%)
Pretax cost savings = $ 169,904.64
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