Question

Your firm is contemplating the purchase of a new $2,164,500 computer-based order entry system. The system will be depreciated straight-line to zero over its 5-year life. It will be worth $210,600 at the end of that time. You will be able to reduce working capital by $292,500 (this is a one-time reduction). The tax rate is 25 percent and your required return on the project is 18 percent and your pretax cost savings are $848,700 per year.

  

a. What is the NPV of this project?

b. What is the NPV if the pretax cost savings are $611,050 per year?

c. At what level of pretax cost savings would you be indifferent between accepting the project and not accepting it?

Answer 1

a]

Operating cash flow (OCF) each year = income after tax + depreciation

In year 5, the working capital is restored to its original level, and hence it is a cash outflow.

profit on sale of equipment at end of year 5 = sale price (its book value is zero)

after-tax salvage value = salvage value - tax on profit on sale of equipment   

NPV is calculated using NPV function in Excel

NPV is $398,148

b]

NPV is -$159,232

c]

The level of pretax cost savings at which you would be indifferent is where the NPV becomes zero.

The level of pretax cost savings at which NPV becomes zero is calculated using GoalSeek in Excel

The level of pretax cost savings at which NPV becomes zero is $678,942