Question

The president of Real Time Inc. has asked you to evaluate the proposed acquisition of a new computer. The computer's price is $ 8 0,000, and it falls into the MACRS 3-year class. Purchase of the computer would require an increase in net operating working capital of $ 7 ,000. The computer would increase the firm's before-tax revenues by $30,000 per year but would also increase operating costs by $ 14 ,000 per year. The computer is expected to be used for 3 years and then be sold for $25,000. The firm's marginal tax rate is 40 percent, and the project's cost of capital is 14 percent.

Answer 1

Computation of annual depreciation:

Year	Cost Basis (B)	Depreciation Rate (R)	Depreciation (C x R)	Accumulated Depreciation
1	$80,000	0.3333	$26,664	$26,664
2		0.4445	$35,560	$62,224
3		0.1481	$11,848	$74,072
4		0.0741	$5,928

Book value at the end of year 3 = Cost basis – Accumulated depreciation

                                                        =$ 80,000 - $ 74,072 = $ 5,928

Computation of annual cash flow:

Year	1	2	3
Revenue	$30,000	$30,000	$30,000
Less: Operating cost	$14,000	$14,000	$14,000
Operating profit	$16,000	$16,000	$16,000
Less: Depreciation	$26,664	$35,560	$11,848
Profit before tax	($10,664)	($19,560)	$4,152
Tax @ 40 %	$0.00	$0.00	$1,660.80
Net Profit (loss)	($10,664)	($19,560)	$2,491.20
Add: Depreciation	$26,664	$35,560	$11,848
Net cash flow	$16,000	$16,000	$14,339.20

Initial cash layout = Cost of equipment + Working capital

                                = $ 80,000 + $ 7,000 = $ 87,000

Terminal cash flow at the end of year 3 = Annual cash flow + Working capital release + after tax salvage value

= $ 14,339.20 + $ 7,000 + MV – [(MV – BV) x Tax rate]

= $ 14,339.20 + $ 7,000 + $ 25,000 – [($ 25,000 – $ 5,928) x 0.4]

= $ 21,339.20 + [$ 25,000 – ($ 19,072 x 0.4)]

= $ 21,339.20 + ($ 25,000 – $ 7,628.80)

= $ 21,339.20 + $ 17,371.20 = $ 38,710.40

Computation of NPV:

NPV = PV of future cash flow – Initial cash layout

Year	Cash Flow (C)	PV Factor Computation	PV Factor @ 14 % (F)	PV (C x F)
0	($87,000)	1/ (1+0.14)0	1.00	$(87,000.00)
1	$16,000.00	1/ (1+0.14)1	0.87719298245614	$14,035.09
2	$16,000.00	1/ (1+0.14)2	0.76946752847030	$12,311.48
3	$38,710.40	1/ (1+0.14)3	$0.67497151620202	26,128.42
			NPV	(34,525.01)

As NPV is negative, there is a loss on acquisition of the computer and hence not recommendable.