Response to the following problem:
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 of project $1,250,000
Depreciation method Straight-line
Salvage value $0
Residual value (sales price at end of project) $350,000
Tax rate (ordinary and capital gains tax) 35%
Incremental annual revenues in year 1 $368,000
Incremental annual expenses in year 1 $198,500
Working capital required at time of investment (t=0) $50,000
Working capital as percentage of revenue each year 12.0%
Cost of capital 12%
Economic life 10 years
Requirements:
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 $198,500 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?