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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$1,250,000
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Depreciation method
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Straight-line
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Salvage value (for depreciation purposes)
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$0
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Residual value (sales price at end of project)
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$350,000
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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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$368,000
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Incremental annual expenses in year 1
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$198,000
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Working capital required at time of investment (t=0)
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$50,000
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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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12%
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Economic life
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10 years
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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 $198,000 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 $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?