Question

eEgg is considering the purchase of a new distributed network computer system to help handle its warehouse inventories. The system costs $65,000 to purchase and install and $34,000 to operate each year. The system is estimated to be useful for 4 years. Management expects the new system to reduce the cost of managing inventories by $67,000 per year. The firm’s cost of capital (discount rate) is 12%.

Required:

1. What is the net present value (NPV) of the proposed investment under each of the following independent situations? (Use the appropriate present value factors from Appendix C, TABLE 1 and Appendix C, TABLE 2.)

1a. The firm is not yet profitable and therefore pays no income taxes.

1b. The firm is in the 20% income tax bracket and uses straight-line (SLN) depreciation with no salvage value. Assume MACRS rules do not apply.

1c. The firm is in the 20% income tax bracket and uses double-declining-balance (DDB) depreciation with no salvage value. Given a four-year life, the DDB depreciation rate is 50% (i.e., 2 × 25%). In year four, record depreciation expense as the net book value (NBV) of the asset at the start of the year.

2. What is the internal rate of return (IRR) of the proposed investment for situations in requirement 1, parts (a) through (c)? Use the IRR builit-in function in Excel to compute the IRR.

eEgg is considering the purchase of a new distributed network computer system to help handle its warehouse inventories. The system costs $65,000 to purchase and install and $34,000 to operate each year. The system is estimated to be useful for 4 years. Management expects the new system to reduce the cost of managing inventories by $67,000 per year. The firm's cost of capital (discount rate) is 12%. Required: 1. What is the net present value (NPV) of the proposed investment under each of the following independent situations? (Use the appropriate present value factors from Appendix C, TABLE 1 and Appendix C, TABLE 2.) 1a. The firm is not yet profitable and therefore pays no income taxes. 1b. The firm is in the 20% income tax bracket and uses straight-line (SLN) depreciation with no salvage value. Assume MACRS rules do not apply. 1c. The firm is in the 20% income tax bracket and uses double-declining-balance (DDB) depreciation with no salvage value. Given a four-year life, the DDB depreciation rate is 50% (i.e., 2 x 25%). In year four, record depreciation expense as the net book value (NBV) of the asset at the start of the year. 2. What is the internal rate of return (IRR) of the proposed investment for situations in requirement 1, parts (a) through (c)? Use the IRR built-in function in Excel to compute the IRR.

Answer 1

1a.

Total Savings p.a. => 67000-34000 = 33000.

Year	Cashflow	Discount factor@ 12%	discounted cashflows
0	-65000	1.000	65000
1-4	33000	3.037	100221
		NPV	35221

1b.

Depreciation (SLM) = 65000/4 = 16250.

Year	Cashflows	Depreciation	Pre tax	Income tax @ 20%	Post taxes	Discount factor @12%	Discounted cashflows
0	-65000				-65000	1.000	65000
1-4	33000	16250	16750	3350	16250-3350+16750 = 29650	3.037	90047
						NPV	25047

1c.

Year	Cashflows	Depreciation	Pre tax	Income tax @ 20%	Post taxes	Discount factor @12%	Discounted cashflows
0	-65000		-65000		-65000	1.000	-65000
1	33000	32500	500	100	32900	0.893	29380
2	33000	16250	16750	3350	29650	0.797	23631
3	33000	8125	24875	4975	28025	0.712	19954
4	33000	8125	24875	4975	28025	0.636	17824
						NPV	25788

2. IRR

a	35.90%
b	29.30%
c	30.40%