Question

eEgg is considering the purchase of a new distributed network computer system to help handle its warehouse inventories. The system costs $56,000 to purchase and install and $31,500 to operate each year. The system is estimated to be useful for 4 years. Management expects the new system to reduce the cost of managing inventories by $60,000 per year. The firm's cost of capital (discount rate) is 9%. Required: 1. What is the net present value (NPV) of the proposed investment under each of the following independent situations? (Use the appropriate present value factors from Appendix C, TABLE 1 and Appendix C, TABLE 2.) 1a. The firm is not yet profitable and therefore pays no income taxes. 1b. The firm is in the 24% income tax bracket and uses straight-line (SLN) depreciation with no salvage value. Assume MACRS rules do not apply. 1c. The firm is in the 24% income tax bracket and uses double-declining-balance (DDB) depreciation with no salvage value. Given a four-year life, the DDB depreciation rate is 50% (i.e., 2 x 25%). In year four, record depreciation expense as the net book value (NBV) of the asset at the start of the year. 2. What is the internal rate of return (IRR) of the proposed investment for situations in requirement 1, parts (a) through (c)? Use the IRR builit-in function in Excel to compute the IRR.

Answer 1

1a.

Year	Reduction in Costs	Annual Expenses	Net Savings	PV Factor @9%	PV
1	$           60,000	$       31,500	$     28,500	0.9174	$         26,146
2	$           60,000	$       31,500	$     28,500	0.8417	$         23,988
3	$           60,000	$       31,500	$     28,500	0.7722	$         22,008
4	$           60,000	$       31,500	$     28,500	0.7084	$         20,189
			Total PV		$         92,331
			Less : Investment		$         56,000
			NPV		$         36,331

1b.

Year	Reduction in Costs	Annual Expenses	Net Savings	Depreciation	Taxable Income	Tax	After Tax net cash flows	PV Factor @9%	PV
1	$           60,000	$       31,500	$     28,500	$         14,000	$         14,500	$         3,480	$ 25,020	0.9174	$ 22,953
2	$           60,000	$       31,500	$     28,500	$         14,000	$         14,500	$         3,480	$ 25,020	0.8417	$ 21,059
3	$           60,000	$       31,500	$     28,500	$         14,000	$         14,500	$         3,480	$ 25,020	0.7722	$ 19,320
4	$           60,000	$       31,500	$     28,500	$         14,000	$         14,500	$         3,480	$ 25,020	0.7084	$ 17,724
					Total PV				$ 81,057
					Less : Investment				$ 56,000
					NPV				$ 25,057

Depreciation = $56000/4 = $14000
Depreciation tax shield = Depreciation x 24%

1c.

Year	Reduction in Costs	Annual Expenses	Net Savings	Depreciation	Taxable Income	Tax	After Tax net cash flows	PV Factor @9%	PV
1	$           60,000	$       31,500	$     28,500	$         28,000	$               500	$            120	$ 28,380	0.9174	$ 26,036
2	$           60,000	$       31,500	$     28,500	$         14,000	$         14,500	$         3,480	$ 25,020	0.8417	$ 21,059
3	$           60,000	$       31,500	$     28,500	$           7,000	$         21,500	$         5,160	$ 23,340	0.7722	$ 18,023
4	$           60,000	$       31,500	$     28,500	$           7,000	$         21,500	$         5,160	$ 23,340	0.7084	$ 16,534
					Total PV				$ 81,652
					Less : Investment				$ 56,000
					NPV				$ 25,652

DDB Depreciation = Beginning Book Value x 50%

2a.

Year	Net Cash Flows
0	$          -56,000
1	$           28,500
2	$           28,500
3	$           28,500
4	$           28,500
IRR	36.03%
IRR	=IRR(B2:B6,10%)

2b.

Year	Net Cash Flows
0	$          -56,000
1	$           25,020
2	$           25,020
3	$           25,020
4	$           25,020
IRR	28.07%
IRR	=IRR(B2:B6,10%)

2c.

Year	Net Cash Flows
0	$          -56,000
1	$           28,380
2	$           25,020
3	$           23,340
4	$           23,340
IRR	29.37%
IRR	=IRR(B2:B6,10%)