Question

eEgg is considering the purchase of a new distributed network computer system to help handle its warehouse inventories. The system costs $60,000 to purchase and install and $28,000 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 $59,000 per year. The firm's cost of capital (discount rate) is 10% 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 26% 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 26% 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% (ie, 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 parts (a) through (c)? Use the IRR built-in function in Excel to compute the IRR Complete this question by entering your answers in the tabs below. Reg 1A Reg 1B Regic Reg 2 The firm is not yet profitable and therefore pays no income taxes. (Round your answer to nearest whole dollar amount.) Net present value Req 18 >

Answer 1

The above question , completely based on Capital Budgeting We need to calculate NPV ( Net present value ) , IRR ( Internal rate of return) - most excel formula based.

NPV Calculation

NPV calculation based on formula - Cash flow /(1+r)t

Cash flow - Net of cash inflow and cash outflow .

r- Discount factor ( as calculated below on the basis of 10% yearly basis )

t- Time period - 5 year

Net inflow - Yearly cash inflow * yearly discount factor

		Yr 0	Yr 1	Yr 2	Yr 3	Yr 4
Initial Investment ($)		-60,000
Cash inflow ($)
Reduced cost ($)	59000		31,000	31,000	31,000	31,000
Operation Cost($)	28000
	31000
Discount rate			0.91	0.83	0.75	0.68
Net Inflow ($)		98,266	28,182	25,620	23,291	21,173
NPV($)		38,266

PV calculation , NPV ( +ve or -ve) on the basis of Pv of cash inflow as well as Cash outflow
To calculate PV , need to determined year wise discount factor
The firm cost of capital(ke)			10%
Discount rate
Year 1	0.909
Year 2	0.826
Year 3	0.751
Year 4	0.683
Sum	3.170

1B) calculated Straight Line basis of deprecation , with Income tax effect , derived NPV .

Need to calculate depreciation on SLM basis and derived profit after tax before Depreciation

Used discount factor ( as discussed above) and derived Cash inflow ( Pv of net profit after tax + dep) .

Discount rate		Tax rate	0.26
Year 1	0.909	Depreciation - Straight Line basis
Year 2	0.826	Original cost($)	60000
Year 3	0.751	Depreciation per year	15000
Year 4	0.683
Sum	3.170

Initial Investment ($)-A	-60,000
Cash inflow ($)
Reduced cost ($)	59,000
Operation Cost($)	28,000
Cash inflow ($)	31,000
Depreciation($)	-15,000
(Original cost/4)
Operating Profit ( before Tax)-$	16,000
Tax( 26%)	4,160
Operating Profit ( After Tax)	11,840
Add-Depreciation	15,000
Profit	26,840
Discount factor	3.1699
Derived Profit after tax)-B	85,079
NPV($)A-B	25,079

1c) depreciation rate change as per DDB system and derived NBV , use same value to derived net profit after tax + depreciation * Discount factor and deduct from Cash Initial Investment = NPV

	Yr 1-$	Yr 2-$	Yr 3-$	Yr 4-$	Total($)
Net Cash inflow	31,000	31,000	31,000	31,000
Less Depreciation	30,000	15,000	7,500	3,750
Net of Depreciation	1,000	16,000	23,500	27,250
Less Tax'26%	260	4,160	6,110	7,085
Profit ( after tax )	740	11,840	17,390	20,165
Add - Depreciation	30,000	15,000	7,500	3,750
Profit ( after tax ) + depreciation	30,740	26,840	24,890	23,915
Discount factor	0.91	0.83	0.75	0.68
Derived Cash inflow	27,945	22,182	18,700	16,334	85,162
Initial Investement					-60000
NPV($)					25,162

Depreciation calculation as below

Depreciation calculation based on DDB
	Original Value	Depreciation rate ( 50%)	Depreciation	Closing Value
	($)	(1/4*2)	($)	($)
Year 1	60,000	0.5	30,000	30,000
Year 2	30,000	0.5	15,000	15,000
Year 3	15,000	0.5	7,500	7,500
Year 4	7,500	0.5	3,750	3,750

2. Calculation of IRR - formula base

IRR -Sum of ( cash outflow and year wise cash inflow) . In below matter , we derived IRR under 3 different scenario. Option 1 - No depreciation,- Only Year wise cash inflow ( as calculated in (1) .

Option 2 - With help of SLM depreciation - as calculated above ( 1b)

Option 3 - Depreciation under DDB method as above (1c)

IRR Formula base	Option 1	Option 2	Option 3
	( No depreciation )	( SLM Depreciation)	( DDB depreciation)
Cah outflow	-60,000	-60,000	-60,000
Cah Inflow
Year 1	31,000	26840	30,740
Year 2	31,000	26840	26,840
Year 3	31,000	26840	24,890
Year 4	31,000	26840	23,915
IRR	37%	28%	29%