Question

Magana, a private limited company in tourism industry, in order to improve customer services and provide management with timely and quality information, the company is contemplating purchasing 6 microcomputers at sh 112000 each. Installation cost for all of them will amount sh 60,000.It is estimated that once installed the company will increase pre-tax operating benefit from sh 11, 769,000 to sh 11,995,000 annually. Computers are expected to last for 8 years after which this will be obsolete with no residue value. The operations manager argues the company needs will have to grow the computers in only 5 years. The computers will be salvaged for 32,000 each after 5 years 30% tax bracket. The cost of capital is 16% and straight line method of depreciation is used to depreciate all fixed assets.

Required.

a] Suppose the probability useful life of these computers is determined as follows;

                  Probability                                         useful life

                  0.3                                                       5 years

                  0.5                                                       8 years

                  0.2                                                       10 years

Determine whether Magana should purchase the computers.

Answer 1

1.Initially, Working out for 5 years
NPV calculations:
PV of :				Depreciation calculations
Initial investment(112000*6)		-672000		Cost of 6 computers	672000
PV of Installation cost		-60000		Installation costs	60000
Incremental Pre-tax Opg. Benefit(11995000-11769000)	226000			Total cost	732000
Less: incremental Tax at 30%	67800			Less: Salvage at Yr.8	192000
Incl. after-tax benefit	158200			Depreciable cost	540000
Add Back depn.(((112000*6)+60000)-(32000*6))/5	108000			Useful life	5 yrs.
Incl. annual opg. Cash flow	266200			Annual depn.	108000
PV of the above at 16%
266200*3.27429		871616
(PVOA F,5 yrs. 16%)
PV of salvage
32000*0.47611		15236
(PV F , 5 yrs. 16%)
NPV of the investment		154852

2…
Probable life=
(0.3*5)+(0.5*8)+(0.2*10)=
7.5
Years
As the probable life extends into the 8th yr.we work out for a period of 8 years
NPV calculations:
PV of :				Depreciation calculations
Initial investment(112000*6)		-672000		Cost of 6 computers	672000
PV of Installation cost		-60000		Installation costs	60000
Incremental Pre-tax Opg. Benefit(11995000-11769000)	226000			Total cost	732000
Less: incremental Tax at 30%	67800			Less: Salvage at Yr.8	0
Incl. after-tax benefit	158200			Depreciable cost	732000
Add Back depn.(((112000*6)+60000)-0)/8	97600			Useful life	7.5 yrs.
Incl. annual opg. Cash flow	255800			Annual depn.	97600
PV of the above at 16%
(255800*4.34359)		1111090
(PVOA F,8 yrs. 16%)
NPV of the investment		379090

Recommended that
Magana should purchase the computers
as NPV of incremental cash flows is POSITIVE , both for 5 yrs. & 7.5 yrs. Useful lives of the 6 computers.