Question

Highland industries is considering the purchase of a new computer system, ZZ, to replace the existing system. The cost of the system is $1.4 million plus $105,000 to install. The old system was purchased 5 years ago and has a book value of $170,000. It can be sold today for $250,000. They will also need an additional $20,000 of working capital when the system is put in place. The new system will save Highland $410,000/year in warehousing costs over the next 4 years. The company's cost of capital is 8% and its tax rate is 21%.

a. What is the initial investment for this project?

b. What is the net present value of the project?

c. What is IRR?

d. If another vendor offers basically the same system, XX, with an initial investment of $1.1 million and $250,000/year of savings for 5 years, which project would you accept? Show your NVP and IRR to decide.

Answer 1

a.Initial Investment=Cost+installation cost-(Old system market price*(1-tax rate))+working capital

Initial investment=$1,400,000+$105,000-(250,000*(1-21%))+20,000

Initial investment=$1,327,500

b.NPV=Present value of future cash inflows-Initial investment

=(410,000/1.08)+(410,000/1.08^2)+(410,000/1.08^3)+(410,000/1.08^4)-1327500

NPV=30,472

EXCEL formula=NPV(rate, Year1 to Year4 cashflows)-Initial investment

rate=8%

c. IRR(year0 to Year 4 cashflows)

IRR=9.03%

d.with an initial investment for project xx, the NPV and IRR looks as below

We shoul go with project ZZ because of its positive NPV and IRR>cost of capital. For project XX,these are negative and lower than cost of capital. Hence, we should go with project ZZ.