You have been asked to help a local company evaluate a major capital expenditure. The

company is a new internet company and must buy a large computer system which will generate

additional revenue. The company provides you with the following information:

Initial cost of project $1,250,000

Depreciation method Straight-line

Salvage value $0

Residual value (sales price at end of project) $350,000

Tax rate (ordinary and capital gains tax) 35%

Incremental annual revenues in year 1 $368,000

Incremental annual expenses in year 1 $198,500

Working capital required at time of investment (t=0) $50,000

Working capital as percentage of revenue each year 12.0%

Cost of capital 12%

Economic life 10 years

 

Requirements:

a. Write a letter to the president of the company explaining whether the company should

acquire the computer system. Utilize both NPV and IRR. Assume that the initial $368,000 in

annual revenues will grow at a 8% annual rate and that the initial $198,500 in annual

expenses will grow at a 5% annual rate. The growth starts in year 2 from year 1, i.e. the

revenue is year 2 is $397,440, etc. Working capital is released at the end of the project.

 

b. Redo this analysis above using sum-of-years digits depreciation method. What happens to the

results and would you change your recommendation?

 

c. Redo this analysis above using MACRS (10 years) depreciation method. What happens to the

results and would you change your recommendation?