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 $1250000
Depreciation method Straight-line
Salvage value $0
Residual value (sales price at end of project) $350000
Tax rate (ordinary and capital gains tax) 35%
Incremental annual revenues in year 1 $368000
Incremental annual expenses in year 1 $198500
Working capital required at time of investment (t=0) $50000
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 $368000 in
annual revenues will grow at a 8% annual rate and that the initial $198500 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 $397440 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?