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:
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Initial cost of project
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$2,500,000
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Depreciation method
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Straight-line
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Salvage value
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$0
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Residual value (sales price at end of project)
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$475,000
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Tax rate (ordinary and capital gains tax)
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35%
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Incremental annual revenues in year 1
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$525,000
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Incremental annual expenses in year 1
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$205,000
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Working capital required at time of investment (t=0)
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$175,000
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Working capital as percentage of revenue each year
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12.0%
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Cost of capital
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10%
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Economic life
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10 years
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Requirements:
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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 $525,000 in annual revenues will grow at an 8% annual rate and that the initial $205,000 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 $567,000, etc. Working capital is released at the end of the project.
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Redo this analysis above using sum-of-years digits depreciation method. What happens to the results and would you change your recommendation?
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Redo this analysis above using MACRS (10 years) depreciation method. What happens to the results and would you change your recommendation?