Task: 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
|
$7,500,000
|
|
Depreciation method
|
Straight-line
|
|
Salvage value
|
$0
|
|
Residual value
|
$500,000
|
|
Tax rate
|
35%
|
|
Incremental annual revenues
|
$7,850,000
|
|
Incremental annual expenses
|
$6,950,000
|
|
Additional working capital required now and released at end of project
|
$500,000
|
|
Cost of capital
|
10%
|
|
Economic life
|
10 years
|
Requirements:
Q1. 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 $7,850,000 in annual revenues will grow at a 6% annual rate and that the initial $6,950,000 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 8,321,000, etc.
Q2. Redo this analysis above using sum-of-years digits depreciation method. What happens to the results and would you change your recommendation?