Question

Your firm is contemplating the purchase of a new $642,000 computer-based order entry system. The system will be depreciated straight-line to zero over its six-year life. It will be worth $46,000 at the end of that time. You will be able to reduce working capital by $41,000 at the beginning of the project. Working capital will revert back to normal at the end of the project. Assume the tax rate is 35 percent.

What is the aftertax salvage value of the equipment?

Suppose your required return on the project is 8 percent and your pretax cost savings are $196,000 per year. What is the annual OCF?

What is the NPV of the project?

Suppose your required return on the project is 8 percent and your pretax cost savings are $136,000 per year. What is the annual OCF?

What is the NPV of the project?

Answer 1

After tax salvage value = Salvage value x (1-tax rate) = $ 46,000 x (1 – 0.35)

                                      = $ 46,000 x 0.65 = $ 29,900

After tax salvage value of the equipment is $ 29,900

Annual depreciation = Cost of equipment/Useful life = $ 642,000/6 = $ 107,000

Annual pretax cost savings = $ 196,000

Computation of Annual cash flow:

Annual cost savings	$196,000
Less: Depreciation	$107,000
PBT	$89,000
Tax @ 35 %	$31,150
Net profit	$57,850
Add: Depreciation	$107,000
Annual OCF	$164,850

Computation of NPV:

NPV = PV of cash inflow - Initial Cost

Year 0 cash flow = Initial cost of equipment + Reduce in working capital

                            = -$ 642,000 + $ 41,000 = - $ 601,000

Annual cash flow from year 1 through 5 = $ 164,850

Cash flow in year 6 = OCF - Reduce in working capital + after tax salvage value

                                = $ 164,850 - $ 41,000 + $ 29,900 = $ 153,750

Year	PV Factor computation	PV Factor @ 8 % (F)	Cash Flow (C)	PV (C x F)
0	1/(1+0.08)^0	1	($601,000)	($601,000.00)
1	1/(1+0.08)^1	0.925925925925926	$164,850	$152,638.89
2	1/(1+0.08)^2	0.857338820301783	$164,850	$141,332.30
3	1/(1+0.08)^3	0.793832241020169	$164,850	$130,863.24
4	1/(1+0.08)^4	0.735029852796453	$164,850	$121,169.67
5	1/(1+0.08)^5	0.680583197033753	$164,850	$112,194.14
6	1/(1+0.08)^6	0.630169626883105	$153,750	$96,888.58
			NPV	$154,086.83

NPV of the project is $ 154,086.83

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Annual pretax cost savings = $ 136,000

Computation of Annual cash flow:

Annual cost savings	$136,000
Less: Depreciation	$107,000
PBT	$29,000
Tax @ 35 %	$10,150
Net profit	$18,850
Add: Depreciation	$107,000
Annual OCF	$125,850

Computation of NPV:

NPV = PV of cash inflow - Initial Cost

Year 0 cash flow = Initial cost of equipment - Reduce in working capital

                           = -$ 642,000 + $ 41,000 = - $ 601,000

Annual cash inflow from year 1 through 5 = $ 125,850

Cash flow in year 6 = OCF - Reduce in working capital + after tax salvage value

                              = $ 125,850 - $ 41,000 + $ 29,900 = $ 114,750

Year	PV Factor computation	PV Factor @ 8 % (F)	Cash Flow (C)	PV (C x F)
0	1/(1+0.08)^0	1	($601,000)	($601,000.00)
1	1/(1+0.08)^1	0.925925925925926	$125,850	$116,527.78
2	1/(1+0.08)^2	0.857338820301783	$125,850	$107,896.09
3	1/(1+0.08)^3	0.793832241020169	$125,850	$99,903.79
4	1/(1+0.08)^4	0.735029852796453	$125,850	$92,503.51
5	1/(1+0.08)^5	0.680583197033753	$125,850	$85,651.40
6	1/(1+0.08)^6	0.630169626883105	$114,750	$72,311.96
			NPV	($26,205.48)

NPV of the project is - $ 26,205.48