Question

Your firm is contemplating the purchase of a new $490,000 computer-based order entry system. The system will be depreciated straight-line to zero over its 7-year life. It will be worth $49,000 at the end of that time. You will be able to reduce working capital by $34,000 at the beginning of the project. Working capital will revert back to normal at the end of the project. Assume the tax rate is 24 percent.

a.

What is the aftertax salvage value of the equipment? (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)

b.

Suppose your required return on the project is 10 percent and your pretax cost savings are $154,000 per year. What is the annual OCF? (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)

What is the NPV of the project? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

c.

Suppose your required return on the project is 10 percent and your pretax cost savings are $95,000 per year. What is the annual OCF? (Do not round intermediate calculations and round your answer to the nearest whole number, e.g.,32.)

What is the NPV of the project? (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Answer 1

Initial Investment = $490,000
Useful Life = 7 years

Annual Depreciation = Initial Investment / Useful Life
Annual Depreciation = $490,000 / 7
Annual Depreciation = $70,000

Initial Investment in NWC = -$34,000

Answer a.

Salvage Value = $49,000

After-tax Salvage Value = Salvage Value * (1 - Tax Rate)
After-tax Salvage Value = $49,000 * (1 - 0.24)
After-tax Salvage Value = $37,240

Answer b.

Annual OCF = Pretax Cost Saving * (1 - Tax Rate) + Tax Rate * Depreciation
Annual OCF = $154,000 * (1 - 0.24) + 0.24 * $70,000
Annual OCF = $154,000 * 0.76 + 0.24 * $70,000
Annual OCF = $133,840

NPV = -$490,000 + $34,000 + $133,840/1.10 + $133,840/1.10^2 + ... + $133,840/1.10^6 + $133,840/1.10^7 + $37,240/1.10^7 - $34,000/1.10^7
NPV = -$456,000 + $133,840 * (1 - (1/1.10)^7) / 0.10 + $3,240 * (1/1.10)^7
NPV = -$456,000 + $133,840 * 4.868419 + $3,240 * 0.513158
NPV = $197,251.83

Answer c.

Annual OCF = Pretax Cost Saving * (1 - Tax Rate) + Tax Rate * Depreciation
Annual OCF = $95,000 * (1 - 0.24) + 0.24 * $70,000
Annual OCF = $95,000 * 0.76 + 0.24 * $70,000
Annual OCF = $89,000

NPV = -$490,000 + $34,000 + $89,000/1.10 + $89,000/1.10^2 + ... + $89,000/1.10^6 + $89,000/1.10^7 + $37,240/1.10^7 - $34,000/1.10^7
NPV = -$456,000 + $89,000 * (1 - (1/1.10)^7) / 0.10 + $3,240 * (1/1.10)^7
NPV = -$456,000 + $89,000 * 4.868419 + $3,240 * 0.513158
NPV = -$21,048.08