# Your firm is contemplating the purchase of a new $657,000 computer-based order entry system. The...

## Question:

Your firm is contemplating the purchase of a new $657,000 computer-based order entry system. The system will be depreciated straight-line to zero over its six-year life. It will be worth $51,000 at the end of that time. You will be able to reduce working capital by $46,000 at the beginning of the project. Working capital will revert back to normal at the end of the project. Assume that the tax rate is 40 per cent.

1) What is the after-tax salvage value of the equipment?

2) Suppose your required return on the project is 9 per cent and your pretax cost savings are $201,000 per year, then

a) What is the annual OCF?

b) What is the NPV of the project?

3) Suppose your required return on the project is 9 per cent and your pretax cost savings are $141,000 per year, then

a) What is the annual OCF?

b) What is the NPV of the project?

## Operating Cash Flow:

The total cash flow that the project is generating from the ordinary business activity is called operating cash flow. Operating cash flow is calculated by adding all the known cash items in the net income of the company.

## Answer and Explanation:

**Given data:**

Computer purchase = $657,000

Salvage value = $51,000

Working capital = $46,000

Tax rate = 40%

**Solving:**

**1)**

Capital gain = Salvage value * Tax rate

Capital gain = 51,000 * 40%

Capital gain = 51,000 * 0.40

Capital gain = $20,400

After tax salvage value = Salvage value - Capital gain

After tax salvage value = 51,000 - 20,400

After tax salvage value = $30,600

**2)**

**a)**

Accounts Title | Amount ($) | Working | |
---|---|---|---|

Depreciation per annum | 109,500 | 657,000/6 | |

Pre-tax cost saving per annum | 201,000 | ||

Less: | Tax @ 40% | 80,400 | |

After Tax cost saving per annum | 120,600 | ||

Add: | Depreciation tax shield | 43,800 | 109,500 * 40% |

Annual operating cash flow | 164,400 |

**b)**

Year | After tax salvage (A) | Changes in working capital (B) | Cost of new system (C) | OCF (D) | Net cash flow other than OCF ((E) = (A) + (B) + (C) + (D)) | DF @ 9% (F) | Present value ((G) = (E) * (F)) |
---|---|---|---|---|---|---|---|

0 | 46,000 | -657,000 | -611,000 | 1 | -611,000 | ||

1 | 164,400 | 164,400 | 0.917 | 150,754.8 | |||

2 | 164,400 | 164,400 | 0.842 | 138,424.8 | |||

3 | 164,400 | 164,400 | 0.772 | 126,916.8 | |||

4 | 164,400 | 164,400 | 0.708 | 116,395.2 | |||

5 | 164,400 | 164,400 | 0.650 | 106,860 | |||

6 | 30,600 | -46,000 | 164,400 | 149,000 | 0.596 | 88,804 |

NPV = 117,155.6

**3)**

**a)**

Accounts Title | Amount ($) | Working | |
---|---|---|---|

Depreciation per annum | 109,500 | 657,000/6 | |

Pre-tax cost saving per annum | 141,000 | ||

Less: | Tax @ 40% | 56,400 | |

After Tax cost saving per annum | 84,600 | ||

Add: | Depreciation tax shield | 43,800 | 109,500 * 40% |

Annual operating cash flow | 128,400 |

**b)**

Year | After tax salvage (A) | Changes in working capital (B) | Cost of new system (C) | OCF (D) | Net cash flow other than OCF ((E) = (A) + (B) + (C) + (D)) | DF @ 9% (F) | Present value ((G) = (E) * (F)) |
---|---|---|---|---|---|---|---|

0 | 46,000 | -657,000 | -611,000 | 1 | -611,000 | ||

1 | 128,400 | 128,400 | 0.917 | 117,742.8 | |||

2 | 128,400 | 128,400 | 0.842 | 108,112.8 | |||

3 | 128,400 | 128,400 | 0.772 | 99,124.8 | |||

4 | 128,400 | 128,400 | 0.708 | 90,907.2 | |||

5 | 128,400 | 128,400 | 0.650 | 83,460 | |||

6 | 30,600 | -46,000 | 128,400 | 113,000 | 0.596 | 67,348. |

NPV = -44,309.4

#### Learn more about this topic:

from Finance 101: Principles of Finance

Chapter 10 / Lesson 4