eEgg is considering the purchase of a new distributed network computer system to help handle its...
eEgg is considering the purchase of a new distributed network computer system to help handle its warehouse inventories. The system costs $41,000 to purchase and install and $25,000 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 $46,000 per year. The firm’s cost of capital (discount rate) is 11%.
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 21% 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 21% 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.
| ESTIMATED IRR | % | |
| a | ||
| b | ||
| c |
Homework Answers
| Ans 1a. | ||||||
| As there is no Tax, the depreciation can be ignored from cash flow as there will | ||||||
| be no Depreciation Tax shield. | ||||||
| NPV | ||||||
| Particulras | Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | |
| a | Initial Investment | (41,000) | ||||
| Cash flow from Operating Activities | ||||||
| Savings due to reduced Inventory Management cost | 46,000 | 46,000 | 46,000 | 46,000 | ||
| Less Operating Cost | (25,000) | (25,000) | (25,000) | (25,000) | ||
| b | Total Cash flow from Operating activities | 21,000 | 21,000 | 21,000 | 21,000 | |
| c | Total Cash Flow =a+b= | (41,000) | 21,000 | 21,000 | 21,000 | 21,000 |
| d | PV Factor @11% | 1 | 0.9009 | 0.8116 | 0.7312 | 0.6587 |
| e | PV of Cash flows=c*d= | (41,000) | 18,919 | 17,044 | 15,355 | 13,833 |
| f | NPV =Sum of PV of Cash flows | 24,150 | ||||
| g | IRR (using excel function)= | 36.44% |
| Ans 1 b. | ||||||
| NPV | ||||||
| Particulras | Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | |
| a | Initial Investment | (41,000) | ||||
| Cash flow from Operating Activities | ||||||
| Savings due to reduced Inventory Management cost | 46,000 | 46,000 | 46,000 | 46,000 | ||
| Less Operating Cost | (25,000) | (25,000) | (25,000) | (25,000) | ||
| Less Depreciation (SL) | (10,250) | (10,250) | (10,250) | (10,250) | ||
| Taxable Income | 10,750 | 10,750 | 10,750 | 10,750 | ||
| Less Tax @21% | 2,258 | 2,258 | 2,258 | 2,258 | ||
| After Tax Income | 8,493 | 8,493 | 8,493 | 8,493 | ||
| Add Back Depreciation | 10,250 | 10,250 | 10,250 | 10,250 | ||
| b | Total Cash flow from Operating activities | 18,743 | 18,743 | 18,743 | 18,743 | |
| c | Total Cash Flow =a+b= | (41,000) | 18,743 | 18,743 | 18,743 | 18,743 |
| d | PV Factor @11% | 1 | 0.9009 | 0.8116 | 0.7312 | 0.6587 |
| e | PV of Cash flows=c*d= | (41,000) | 16,885 | 15,211 | 13,705 | 12,346 |
| f | NPV =Sum of PV of Cash flows | 17,147 | ||||
| g | IRR (using excel function)= | 29.42% |
| Ans 1 c. | |||||||||||
| NPV | Depreciation Caculation by DDB | ||||||||||
| Particulras | Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year | Opening Asset Book Value | Depreciation @50% | Closing Asset Book Value | ||
| a | Initial Investment | (41,000) | 1 | $ 41,000 | $ 20,500 | $ 20,500 | |||||
| Cash flow from Operating Activities | 2 | $ 20,500 | $ 10,250 | $ 10,250 | |||||||
|
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