Question

The Eaton Company is a national manufacturer of consumer goods and is looking at purchasing a new computer system that will result in a reduction in total operating costs. The purchase cost of the computer system is $540,000. This cost will be fully depreciated using the straight line method over the equipment’s 5 year life. At the end of the 5th year, the company plans on selling the computer equipment. While it is unknown at this time how much the equipment can be sold for, management has assigned $80,000 as its potential salvage value. The company’s accounting policy is not to subtract salvage value from the purchase cost for purposes of calculating depreciation expense. Management believes that the new computer system can save the firm $170,000 per year in pre-tax operating costs. Equally important is that these cost savings can be considered the same as incremental revenues for the firm. In addition, the computer system requires an initial investment in net working capital of $29,000 which is assumed to be recovered or paid back at the end of the 5th year. The company’s tax rate is 34% and its required return on all new capital expenditures is 10%. There are no incremental new expenses to consider.

Question: Calculate the NPV and IRR for this project. Do you accept or reject this project?

Professor’s Note - To properly do this, you will need to create several schedules as follows: 1. Prepare the Pro – Forma Income Statement 2. Calculate the Annual Operating Cash Flow 3. Calculate the After Tax Salvage Value 4. Create a chart showing the Project’s Annual Cash Flows for Year 0 through Year 5. 5. Calculate NPV and IRR. Show the keystrokes you used

Answer 1

1-	proforma Income statement
	Incremental revenue		170000
	less annual depreciation =540000/5		108000
	operating profit		62000
	less taxes-34%		21080
	after tax profit		40920
2-	annual operating cash flow
	after tax profit	40920
	add depreciation	108000
	annual operating cash flow	148920
3-	after tax salvage value	salvage value*(1-tax rate)	80000*(1-.34)	52800
4-	annual cash flow
5-	Year	0	1	2	3	4	5
	cost of computer	-540000
	Investment in working capital	-29000
	annual operating cash flow		148920	148920	148920	148920	148920
	add after tax salvage value						52800
	recovery of working capital						29000
	net operating cash flow or cash flow	-569000	148920	148920	148920	148920	230720
	present value of cash flow = net operating cash flow/(1+r)^n r = 10%	K701/1.1^0	L701/1.1^1	M701/1.1^2	N701/1.1^3	O701/1.1^4	P701/1.1^5
	present value of cash flow = net operating cash flow/(1+r)^n r = 10%	-569000	135381.8182	123074.3802	111885.8002	101714.364	143259
	NPV = sum of present value of cash flow	SUM(K704:P704)	46315.32993
	IRR = Using IRR function in MS excel	IRR(K701:P701)	12.94%
	Yes we shall accept the project as its NPV is greater than 0 and IRR is more than required return of 10%