Question

Kerfuffle Corporation is considering the purchase of a new computer system. The cost for the new system, net of set-up and delivery costs, will be $1.6 million. The new system will provide annual before-tax cost savings of $500,000 for the next five years. The increased efficiency of the new system will lower net working capital by $200,000 today. The CCA rate on the new system will be 30%. At the end of five years, the system can be salvaged for $100,000. The firm’s required rate of return is 15%, and its marginal tax rate is 35%. What is the NPV of this cost-cutting project?

Answer 1

Calculation of NPV of cost-cutting project
Year	0	1	2	3	4	5	NPV
Investment in new system	-$1,600,000.00
Reduction in working capital	$200,000.00
Cost savings		$500,000.00	$500,000.00	$500,000.00	$500,000.00	$500,000.00
Tax @ 35% on savings		-$175,000.00	-$175,000.00	-$175,000.00	-$175,000.00	-$175,000.00
Depreciation tax shield		$168,000.00	$117,600.00	$82,320.00	$57,624.00	$40,336.80
After tax salvage value						$159,119.20
Increase in working capital						-$200,000.00
Net Cash flow	-$1,400,000.00	$493,000.00	$442,600.00	$407,320.00	$382,624.00	$324,456.00
X Discount factor @ 15%	1.00000	0.86957	0.75614	0.65752	0.57175	0.49718
Present Values	-$1,400,000.00	$428,695.65	$334,669.19	$267,819.51	$218,766.51	$161,311.97	$11,262.84
NPV of the cost cutting project =		$11,262.84
Working
Calculation of CCA depreciation
Year	CCA rate	Depreciation	Ending balance	Tax shield on Depreciation @ 35%
0	30%	0	1600000	-
1	30%	480000	1120000	168,000.00
2	30%	336000	784000	117,600.00
3	30%	235200	548800	82,320.00
4	30%	164640	384160	57,624.00
5	30%	115248	268912	40,336.80
Calculation of after tax salvage value of new system
Book value of system at the end of 5th year			268,912.00
Less : Sale value			100,000.00
Loss on sale			168,912.00
Tax shield due to loss on sale (35% of loss)			59,119.20
After tax salvage value (sale value + tax shield)			159,119.20