Question

Your firm is contemplating the purchase of a new $700,000 computer-based entry system. The system will be depreciated straight-line to zero over its five year life. It will be worth $60,000 at the end of that time. You will need to increase your working capital by $81,000 by purchasing additional inventory at the beginning of the project (this is a one-time increase). The tax rate is 34 percent and the required return on the project is 15 percent.

If the pretax cost savings are 344,000 per year, what is the NPV of the project?

Answer 1

Cash Outflows = New Purchase of computer based entry system + Additional Inventory = 700000+81000 = $781,000

Depreciation every year on the system= $700,000/5 = $140,000

Cash Inflows is shown in the following table

Item	Years	Amount	Tax	After Tax Cash	Discounting Rate	PV of Cash Flow
Annual Cash Savings	1-5	344000	0.66	227040	3.3522	761083.49
Depreciation Tax Shield 1-5	140000	0.34	47600	3.3522	159564.72
Residual Value	5	60000	0.66	39600	0.4972	19688.20
					Total	940336.41

The discounting rates for year 1 is .8696, for year 2 is .7561, for year 3 is .6575, for year 4 is .5712 and for year 5 is .4972. The sum value of all discounting rates for the 5 years is 3.3522. The residual value of the system is taxed because there is a capital gain and hence, the value of the taxed residual value is taken into consideration.

Net Present Value = Cash Inflows - Cash Outflows = 940336.41 -781000 = $159,336.41