Your company contemplates buying a computer based inventory management system for 200 000. It will depreciated on a straight line basis to zero over its 4 year life span, when it will be sold for 30 000. the system will save the firm 60 000 pre-tax (EBIT) per annum in operating cost
In addition it is more efficient and will allow you firm to carry less inventory so that it reduces working capital by 45 000
The cost of capital is 16% and capital gains are taxed @ 29%
Calc the initial investment for the new computer based system
the operating cash inflow in year 1,2,3
calc the terminal cash inflow
the net present value
the internal rate of return
To calculate the initial investment for the new computer-based system, we need to subtract the terminal cash inflow from the purchase cost of the system.
Initial investment = Purchase cost - Terminal cash inflow
Purchase cost = $200,000
Terminal cash inflow = $30,000
Initial investment = $200,000 - $30,000 = $170,000
To calculate the operating cash inflow in years 1, 2, and 3, we need to consider the annual savings in operating costs.
Operating cash inflow = Pre-tax savings in operating costs - Taxes
Pre-tax savings in operating costs = $60,000
Since the operating cost savings are pre-tax, we need to calculate the tax amount using the tax rate.
Tax rate = 29% (given)
Tax = Pre-tax savings * Tax rate
Tax = $60,000 * 29% = $17,400
Operating cash inflow = $60,000 - $17,400 = $42,600
Now, let's calculate the terminal cash inflow. The terminal cash inflow is the sales price of the system minus the tax on the capital gains.
Terminal cash inflow = Sales price - Tax on capital gains
Sales price = $30,000
Tax rate on capital gains = 29% (given)
Tax on capital gains = Sales price * Tax rate
Tax on capital gains = $30,000 * 29% = $8,700
Terminal cash inflow = $30,000 - $8,700 = $21,300
To calculate the net present value (NPV), we need to discount the cash flows using the cost of capital.
NPV = Present value of inflows - Initial investment
The present value of inflows in years 1, 2, and 3 can be calculated using the formula:
Present value = Cash inflow / (1 + Cost of capital)^n
Where n represents the year (1 for year 1, 2 for year 2, and so on) and the cost of capital is 16%.
Year 1 cash inflow = $42,600
Year 2 cash inflow = $42,600
Year 3 cash inflow = $42,600
Present value of inflows = (Year 1 cash inflow / (1 + 0.16)^1) + (Year 2 cash inflow / (1 + 0.16)^2) + (Year 3 cash inflow / (1 + 0.16)^3)
Now, let's calculate the NPV:
NPV = Present value of inflows - Initial investment
To calculate the internal rate of return (IRR), we can use the NPV formula and find the discount rate at which NPV becomes zero. We can use trial and error or financial calculators/spreadsheets to find the IRR.