Question

Capital Budgeting (1) MSM Company is planning an upgrade to its warehouse. The upgrade involves computerizing many of the material handling activities. The cost of the upgrade is expected to be $3,500,000. The equipment falls into the 7 year IRS depreciation range (use straight line full year every year) and is expected to provide annual cash cost savings and other annual cash benefits totaling $900,000. At the end of year 3 a one-time fully tax deductible software upgrade of $45,000 will be made. This upgrade is fully tax deductible in year 3. MSM is in the 35% tax bracket and has decided to use a 12% hurdle rate, as a first pass, to examine the financial viability of the proposed project. At the end of year 6 the used equipment is expected to be sold for $420,000. (1) Prepare a well-organized schedule that concludes with the calculation of the expected NPV from this project. (2) Is the Internal Rate of Return above or below the 12% hurdle?

Answer 1

Answer is given below

Straight line depreciation is calculated based on (Cost of Asset- Salvage value )/ life of asset

NPV of the project is negative and IRR is below hurdle rate of 12%

Cash Cost savings Less: Deprecation Taxable income Tax at 35% Income after tax Add: Depreciation Annual cash inflow $900,000 $513,333($3,500,000-$420,000)/ 6 years $386,667 $135,333 $251,333 $513,333 non-cash expense $764,667 1) $764,667 4.1114 $3,143,856 ($45,000*(1-35%) $29,250 0.7118 Calculation of Net present value Annual cash inflow Present value factor 12% for 6 years Present value of cash inflows Year 3 software cost net of tax Present value factor 12% for 3rd year Present value of cash outflow Salvage value after tax Present value factor 12% for 6th year Present value of Salvage value Total Present value of Cash inflows Less: Initial investment Net present value $273,000 0.5066 -$20,820 ($420,000*(1-35%) $138,310 $3,261,347 $3,500,000 -$238,653 2) Calculation of IRR Year Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 IRR Cash (outflows) Inflows -$3,500,000 $764,667 $764,667 $735,417 ($764,667-$29,250) $764,667 $735,417 $1,037,667 ($764,667+$273,000) 9.47% IRR is below the hurdle rate of 12%