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A security team for a local high school contemplates replacing their current contract security system with...

A security team for a local high school contemplates replacing their current contract security system with a new and improved version. It will cost $450,000 to get the new system and the cost will be depreciated straight-line to 0 over the system’s 4-year expected life. The system is expected to be worth $250,000 at the end of 4 years. The security team believes that the new system will save them $125,000 per year (before taxes) in contract security costs. The tax rate is 34%, the required rate of return is 17%.

What is the NPV (Net Present Value) for buying the new system? SHOW EBIT, OCF, CS, and PROJECT CASH FLOW for each year of the project’s life.

Solutions

Expert Solution

Cost of new system = $450000

Initial Cash outflow in year 0 = - Cost of New system = - 450000

Annual Straight line depreciation = (Cost of system - Book value at end of 4 years) / 4 = (450000 - 0) / 4 = 112500

Since the system will save costs, therefore incremental costs for year 1 to 4 = - 125000

Incremental revenue for year 1 to 4 = 0

EBIT for year 1 to 4 = (Incremental Revenue - Incremental costs - Depreciation) = [ 0 - (-125000) - 112500] = 125000 - 112500 = 12500

Operating cash flow for year 1 to 4 = OCF = EBIT(1-tax rate) + Depreciation = 12500(1-34%) + 112500 = 12500 x 66% + 112500 = 8250 + 112500 = 120750

Salvage value of system at end of 4 years = 250000

Terminal cash flow for year 4 = Salvage value of system at end of 4 years - tax on gain from sale of system = Salvage value of system at the end of 4 years - tax rate (Salvage value of system at end of 4 years - Book value of system at end of 4 years) = 250000 - 34%(250000 - 0) = 250000 - 85000 = 165000

Cash Flow Projections:

Year 0 1 2 3 4
Initial Cash Outflow (a) -450000
Operating Cash Flow (b) 120750 120750 120750 120750
Terminal Cash Flow (c) 165000
Net Cash Flow = (a) + (b) + (c) -450000 120750 120750 120750 285750

Net Present value of buying new system = Initial cash outflow + Sum of present values of Net cash flows for year 1 to 4 discounted at 17%

= -450000 + 120750 / (1 + 17%) + 120750 / (1 + 17%)2 + 120750 / (1 + 17%)3 + 285750 / (1 + 17%)4

= -450000 + 103205.1282 + 88209.5112 + 75392.7446 + 152490.5012 = -30702.1148 = -30702.11

Hence the Net present value of buying new system = -30702.11

jeff jeffy answered 1 year ago
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