The IT Department within your corporation is considering the purchase of a new computer for data processing. The purchase price is $150,000 delivered and installed. It has been estimated that the new computer will produce annual savings of $50,000 in enhanced productivity as compared with the current computer.

Your Finance department assumes the new computer will have an economic life of five years, at which time it will be essentially obsolete and have zero salvage value over the costs of removal.

The present computer, which is fully depreciated, is in good working order and could conceivably be used for at least five more years, but its present salvage value is zero, net of all cost of removal. The company has adopted a hurdle rate of 12 percent.

For ease in calculation, assume the marginal tax rate is 50 percent, that the new computer will be straight-line depreciated over no less than five years, and that the cash flows occur in a lump sum at year’s end.

Show that the company cannot justify the computer on purely economic grounds. What happens if the flows are assumed to occur quarterly?

What would the salvage value of the present computer have to be to make the new computer attractive? Assume that the salvage income is subject to the 50 percent tax rate. Why does the old computer’s salvage value influence the new computer’s attractiveness?

Suppose again that the present computer has zero salvage value. What would the salvage value of the new computer at the end of its five-year life have to be to make the new computer attractive? Assume that the book value of the computer at the end of year five is zero.