Question

Company Delta is trying to decide which of the two IT systems to install. Syske 10 million euro and will increase operating profits by 5 million euro per year. Its useful life is five years. Because of rapid technological change, it will have no salvage walue of this time. System 2 costs 15 million euro and will increase operating profits by 8 million euro per year. Its useful life also 5 years, it also will have no salvage value. For tax purposes the company can depreciate either computer system on a straight-line basis.
a) Suppose the company's tax rate is 40% and its cost of capital for either IT system is 10 per cent.
Which system should it buy?
b) If no depreciation is allowed, which IT system is a better choice?

Answer 1

system 1
year	0	1	2	3	4	5
cost of system	-10
operating profit		5	5	5	5	5
after tax profit = operating profit *(1- tax rate)   tax = 40%		3	3	3	3	3
net operating cash flow = profit after tax+depreciation    depreciation = 10/5 = 2	-10	5	5	5	5	5
Present value of cash flow = cash flow/(1+r)^n r =10%	-10.00	4.545454545	4.132231405	3.756574005	3.415067277	3.10460662
NPV = sum of present value of cash flow	8.95
system 2
year	0	1	2	3	4	5
cost of system	-15
operating profit		8	8	8	8	8
after tax profit = operating profit *(1- tax rate)   tax = 40%		4.8	4.8	4.8	4.8	4.8
net operating cash flow = profit after tax+depreciation    depreciation = 15/5 = 3	-15	7.8	7.8	7.8	7.8	7.8
Present value of cash flow = cash flow/(1+r)^n r =10%	-15.00	7.09	6.446280992	5.860255447	5.327504952	4.84318632
NPV = sum of present value of cash flow	14.57
System 2 is better as NPV is greater than System 1
2- If depreciation is not allowed
system 1
year	0	1	2	3	4	5
cost of system	-10
operating profit		5	5	5	5	5
after tax profit = operating profit *(1- tax rate)   tax = 40%		3	3	3	3	3
net operating cash flow = profit after tax+depreciation	-10	3	3	3	3	3
Present value of cash flow = cash flow/(1+r)^n r =10%	-10.00	2.73	2.479338843	2.253944403	2.049040366	1.86276397
NPV = sum of present value of cash flow	1.37
system 2
year	0	1	2	3	4	5
cost of system	-15
operating profit		8	8	8	8	8
after tax profit = operating profit *(1- tax rate)   tax = 40%		4.8	4.8	4.8	4.8	4.8
net operating cash flow = profit after tax	-15	4.8	4.8	4.8	4.8	4.8
Present value of cash flow = cash flow/(1+r)^n r =10%	-15.00	4.36	3.966942149	3.606311044	3.278464586	2.98042235
NPV = sum of present value of cash flow	3.20
System 2 is better as NPV is greater than System 1