Question - The head of the corporate tax division of a major public relations firm has proposed investing $295,000 in personal computers for the staff. The useful life and recovery period for the computers are both 5 years. The firm used MACRS depreciation. There is no terminal salvage value. Labor savings of $125,000 per year (in year-zero dollars) are expected from the purchase. The income tax rate is 45% and the after tax required rate of return is 20%, which includes a 4% element attributable to inflation.
1) Compute the NPV of the computers. Use the nominal required rate of return and adjust the cash flows for inflation (For example, year 1 cash flow = 1.04 x year 0 cash flow).
2) Compute the NPV of the computers using the nominal require rate of return without adjusting the cash flow for inflation.
3) Compare your answers in numbers 1 and 2. Which is correct? Would using the incorrect analysis generally lead to overinvestment or underinvestment? Explain.