Firm is contemplating the purchase of a new warehouse inventory management system which will cost 3,600,000 at the end of its 8 year life. The warehouse management system will be depreciated straight line to 300,000 over its 8 year life. It is estimated it will reduce costs by 700,000 per year. Also it's initial implementation will result in a permanent reduction of working capital of 400,000. The tax rate is 40%
What is the initial investment (Investment in year 0)?
A. 2,100,000
B. 2,400,000
C. 3,200,000
D. 3,600,000
E. 4,000,000
To calculate the initial investment for the warehouse management system, we need to consider the cash flows associated with its purchase and implementation.
1. Purchase cost: The system will cost $3,600,000 at the end of its 8-year life. However, we need to discount this cash flow to its present value considering that it will occur at the end of the 8th year. To calculate the present value, we will discount this amount using the concept of time value of money. We can use the formula for Present Value (PV) of a future cash flow:
PV = FV / (1 + r)^n
FV = Future Value ($3,600,000)
r = Discount rate (Not given, we will assume it to be 10% for illustrative purposes)
n = Number of periods (8 years)
Using the formula, the present value of the purchase cost is:
PV = $3,600,000 / (1 + 0.10)^8
2. Depreciation: The system will be depreciated straight line to $300,000 over its 8-year life. However, since depreciation is a non-cash expense, it does not impact the initial investment calculation. Therefore, we don't need to consider depreciation in this case.
3. Cost savings: The system is estimated to reduce costs by $700,000 per year. However, we are interested in the net cash flow in the year of implementation (year 0). Since the system will result in a permanent reduction of working capital of $400,000, we subtract this amount from the cost savings:
Net Cash Flow = Cost savings - Permanent reduction in working capital
= $700,000 - $400,000
4. Tax impact: The tax rate is given as 40%. We need to calculate the tax savings resulting from the depreciation expense, which is the amount of depreciation multiplied by the tax rate:
Tax Savings = Depreciation expense * Tax rate
= $300,000 * 0.40
Now that we have all the components, we can calculate the initial investment:
Initial Investment = PV of purchase cost + Net Cash Flow - Tax Savings
You can now calculate the initial investment using the provided figures and formulas.