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:
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Initial cost
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$1,000,000
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Depreciation method for requirement a)
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Straight-line
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Depreciation method for requirement b)
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Sum-of-Years Digits
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Salvage value
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$0
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Residual value (Value at end of project)
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$25,000
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Tax rate
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35%
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Incremental annual revenues in year 1
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$227,000
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Incremental annual expenses in year 1
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$77,500
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Additional working capital required now and released at end of project
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$10,000
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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:
a. Write a letter to the president of the company explaining whether the company should acquire the computer system. Show your complete analysis. Utilize both NPV and IRR. Assume that the initial $227,000 in annual revenues will grow at a 6% annual rate each year ($240,620 in year 2, etc.) and that the initial $77,500 in annual expenses will grow at a 5% annual rate each year ($81,375 in year 2, etc.).
b. Redo this analysis above using sum-of-years digits depreciation method. What happens to the results and would you change your recommendation?