Question

Your corporation is faced with the decision of which Word Processor to purchase for its manuscript typing pool (think ‘Mad Men’ here). It can buy the Hack brand processor software package at an aggregate (multi-copy licenses) up-front expense of $80,000, which would also require $20,000 in annual year-by-year maintenance/upkeep expenses. Hack initial cost would be depreciated on a straight-line basis to z ZERO terminal book balue at the end of its four-year useful life. This package’s software and supporting hardware would be obsolete-and therefore totally worthless- in any resale market at that time. Alternatively, your firm might instead invest in the Plager WP technology, with an associated intial investment outlay of $42,000, but annual maintenance/upkeep expenses of $35,000 per year over its three-year useful project life. By-then-ancient Plager software/hardware is expected to command overseas (a Polish zloty equivalent) $4000US from a Central European newspaper company three years from now. Depreciation for this second alternative would also be straight-line, written down to a ZERO terminal book value. Both investments require $5000 of net working capital (NWC) in the first three years of project lives. Your company faces a 36% marginal corporate tax rate, while cost of new capital for replacement cost projects (such as Hack and Plager) is estimated to be 10%.

Use the formulat-driven CB approach to generate after-tax profit margins & depreciation tax shield estimates; thereby allowing you to estimate each project’s Operating Cash Flow (OCF) per year (assumed constant). SHOW WORK.

Considering all other relevant cash flows associate with the Hack and Plager word processor ‘behind the scenes’ replacement cost projects, determine their NPV’s.

Allowing for projects’ unequal lives, which should be undertaken? SHOW ALL WORK & FULLY EXPLAIN your decision.

Answer 1

For the project 1: Cost at y₀ = 80000

Annual maintenace cost y₁to y4= 20000*(1-.36)* 3.170= 40576

cost of net working capital = 7958 (5000*0.64*2.487)

benfit: depreciation saving y1 to y4 = 22824(80000/4 = 20000 , 20000* .36= 7200 , 7200*3.170=22824)

net cost = 105710(80000+40576+7958-22824)

equated annual cost = 33347 (105710/3.17)

Cost of project 2:

initial cost at yo= 42000

annual mintenance cost from y1 to y3 = 55709(35000*0.64 *2.487)

cost of net working capital = 7958 (5000*0.64*2.487)

other cost at y3= 1923(4000*0.64*.751)

benefit- deprection tax saving = 12535 (5040*2.487) (42000/3 = 14000*.36= 5040)

net cost = 95055(42000+55709+7958+1923-12535)

equated annal cost =38221 (99505/2.487)

Decions: It's beeter to choose to project 1st as it's equated annula cost is lower than project 2.