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:

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Operating Cash Flow: Definition & Examples

from Finance 101: Principles of Finance

Chapter 10 / Lesson 4
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