Question

Your firm is contemplating the purchase of a new $400,000 computer-based order entry system. The system will be depreciated straight-line to zero over its 5-year life. It will be worth $31,000 at the end of that time. You will be able to reduce working capital by $30,000 at the beginning of the project. Working capital will revert back to normal at the end of the project. Assume the tax rate is 21 percent.

a. What is the aftertax salvage value of the equipment?

b. Suppose your required return on the project is 8 percent and your pretax cost savings are $136,000 per year. What is the annual OCF? What is the NPV of the project?

c. Suppose your required return on the project is 8 percent and your pretax cost savings are $90,000 per year. What is the annual OCF? What is the NPV of the project?

Answer 1

Initial Investment = $400,000
Useful Life = 5 years

Annual Depreciation = Initial Investment / Useful Life
Annual Depreciation = $400,000 / 5
Annual Depreciation = $80,000

Initial Investment in NWC = -$30,000

Answer a.

Salvage Value = $31,000

After-tax Salvage Value = $31,000 * (1 - 0.21)
After-tax Salvage Value = $24,490

Answer b.

Annual Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Annual Operating Cash Flow = $136,000 * (1 - 0.21) + 0.21 * $80,000
Annual Operating Cash Flow = $136,000 * 0.79 + 0.21 * $80,000
Annual Operating Cash Flow = $124,240

NPV = -$400,000 + $30,000 + $124,240 * PVA of $1 (8%, 5) + $24,490 * PV of $1 (8%, 5) - $30,000 * PV of $1 (8%, 5)
NPV = -$400,000 + $30,000 + $124,240 * 3.99271 + $24,490 * 0.68058 - $30,000 * 0.68058
NPV = $122,304.29

Answer c.

Annual Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Annual Operating Cash Flow = $90,000 * (1 - 0.21) + 0.21 * $80,000
Annual Operating Cash Flow = $90,000 * 0.79 + 0.21 * $80,000
Annual Operating Cash Flow = $87,900

NPV = -$400,000 + $30,000 + $87,900 * PVA of $1 (8%, 5) + $24,490 * PV of $1 (8%, 5) - $30,000 * PV of $1 (8%, 5)
NPV = -$400,000 + $30,000 + $87,900 * 3.99271 + $24,490 * 0.68058 - $30,000 * 0.68058
NPV = -$22,790.79