Your firm is contemplating the purchase of a new 1924000 com

Your firm is contemplating the purchase of a new $1,924,000 computer-based order entry system. The system will be depreciated straight-line to zero over its 5-year life. It will be worth $187,200 at the end of that time. You will be able to reduce working capital by $260,000 (this is a one-time reduction). The tax rate is 31 percent and your required return on the project is 23 percent and your pretax cost savings are $640,200 per year. 1. What is the NPV for this project? 2. What is the NPV if the pretax cost savings are $889,200 per year? 3.At what level of pretax cost savings would you be indifferent between accepting the project and not accepting it?

Solution

Straight Line Depreciation Expense= (Cost - Residual value) / Useful Value

= ( $ 1924000- $ 187200) / 5

= $ 347360

Therefore Annual Depreciation Expense= $ 347360.

To evaluate the project with pretax cost savings of $640200, we need to calculate the Operating Cash Flow (OCF)

Given Tax Rate=31%

OCF= $ 640200( 1-.31) + 0.31( 347360)

OCF= $ 441738 + $ 107682

OCF= $ 549420

The aftertax salvage value= $ 187200 (1-.31)

= $ 129168

Given Required return= 23%

NPV= -$1924000 + $ 640200 + $549420 (PVIFA 23%,5) + [ ( $ 129168 - $ 640200) / (1.23) ^5 ]

PVIFA= (1-(1+r) ^ -N) / r

r= 23 %

N= 5

PVIFA=2.8035

NPV= -$1924000 + $ 640200 + $549420 * 2.8035 + [ ( $ 129168 - $ 640200) / (1.23) ^5 ]  

NPV= -$1924000 + $ 640200 + $1540299 - $ 181217

NPV= $ 75282

If pretax savings is $ 889200

NPV= -$1924000 + $ 889200 + $549420 * 2.8035 + [ ( $ 129168 - $ 889200) / (1.23) ^5 ]

NPV= -$1924000 + $ 889200 + $ 1540299 -$ 269514

NPV= $ 235985.