Question

Pappy’s Potato is contemplating the purchase of a new $495,000 computer-based order entry system. The company plans to use this new system for the next 6 years. However, the system will be depreciated straight-line to zero over the next nine-year life. At the end of the 6th year, the system will be sold for an expected liquidation value of $45,000. You will save $235,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $65,000 at the beginning of the project. Working capital will revert back to normal at the end of the 6th year when the project will be terminated. If the tax rate is 35 percent and the required rate of return for the project is 18%, what is the NPV for this project?

Answer 1

Cost of Computer based order entry System	$495,000
Useful life of Asset	6	years
At the end of 6th year realizable value	$45,000
Per year reduction of order processing cost	$235,000
Tax Rate	35%
After tax order processing cost	$ 152,750.00
$ 235,000 x (1-35%)
Required rate of return	18%
Present value of after tax reduced cost	=152750*((1-(1+0.18)^-6)/0.18)	=	534258.8
PV = periodic value x ((1-(1+ i)^-6)/i
Present value of Increase in Working capital after 6 years	=	65000/(1+0.18)^6
	=	24078.05
Yearly Depreciation ( 495,000/9)	$55,000
yearly Tax benefit on deduction of Depreciation	$19,250
Present value of tax savings [ PV = periodic value x ((1-(1+ i)^-6)/I ]	= 19250*((1-(1+0.18)^-6)/0.18)	=	67328.85
Calculation of NPV
Present value of Cash outflows
Cost of Computer based order entry System (outflow)	$ 495,000.00
Present value of Increase in Working capital after 6 years	$    24,078.05
Total of PV of Cash out flows [A]	$ 519,078.05
Present value of Cash inflows
Present value of after tax reduced cost ( 6 yealy amounts discounted)	$ 534,258.79
Present value of tax savings on Dedction of Depreciation	$    67,328.85
Present value of Salvage value	$    16,669.42
Reduction of Working capital at the beginning	$    65,000.00
Total of PV of Cash inflows [B]	$ 683,257.06
Net Present Value [C]= B-A	$ 164,179.01