Question

Your firm is contemplating the purchase of a new $684,500 computer-based order entry system. The system will be depreciated straight-line to zero over its 5-year life. It will be worth $66,600 at the end of that time. You will be able to reduce working capital by $92,500 (this is a one-time reduction). The tax rate is 21 percent and your required return on the project is 21 percent and your pretax cost savings are $203,750 per year.

At what level of pretax cost savings would you be indifferent between accepting the project and not accepting it?

Answer 1

Year 0 cash outflow= Initial outflow - Wroking capital realised

= $684500-$92500= $592000

Year 5 cash outflow = WC realised - Salvage value post tax

= -$92500+$66600(1-0.21) = -$39886

Depreciation = Cost / Life = $684500 / 5 = $136900

To be indifferent, we will first calculate the present value of the cost and terminal cash flows (Salvage value + Working capital released)

Present value of these cash flows @ 21% is:

Years	Total Benefits/ (Outflow) (a)	Discounting Factor (b ) = (1/1+r)^n	P.V. (c ) = (axb)
0	(592000)	1.0000	(592000)
1	-	0.8264	-
2	-	0.6830	-
3	-	0.5645	-
4	-	0.4665	-
5	(39886)	0.3855	(15376)
	SUM (NPV)		(607378)

Annual operating cash flows required
= Present value calculated above / PVAF(r,n)
= $607378 / PVAF(21%,5 years)
= $607378/ 2.9260
= $207580

Annual operating cash flow required = $207580

Less: Depreciation = $684500 / 5 = $136900

Operating income after tax = $70680

Operating income before tax = 70680 / (100 - Tax Rate) = 70680/ 79% = $89468

Add: Depreciation = $136900

Pre tax savings required to be indifferent = $226368 per year