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Chapter 10

Q. 10.S-T.3

Spending Money to Save Money? For help on this one, refer back to the computerized inventory management system in Example 10.3. Here, we’re contemplating a new automatic surveillance system to replace our current contract security system. It will cost $450,000 to get the new system. The cost will be depreciated straight-line to zero over the system’s four-year expected life. The system is expected to be worth $250,000 at the end of four years after removal costs.
We think the new system will save us $125,000, before taxes, per year in contract security costs. The tax rate is 34 percent. What are the NPV and IRR on buying the new system? The required return is 17 percent.

Step-by-Step

Verified Solution

The $125,000 pretax saving amounts to (1-.34)×$125,000=$82,500 after taxes. The annual depreciation of $450,000/4=$112,500 generates a tax shield of .34 $112,500 $38,250 each year. Putting these together, we calculate that the operating cash flow is $82,500+38,250=$120,750.
Because the book value is zero in four years, the aftertax salvage value is (1-.34)×$250,000=$165,000. There are no working capital consequences, so the cash flows are:

Year
4 3 2 1 0
$120,750 $120,750 $120,750 $120,750 Operating cash flow
\underline{165,000} ________________ ________________ ________________ $-\underline{450,000} Capital spending
$\underline{\underline{285,750}} $\underline{\underline{120,750}} $\underline{\underline{120,750}} $\underline{\underline{120,750}} $-\underline{\underline{450,000}} Total cash flow

You can verify that the NPV at 17 percent is -$30,702, and the return on the new surveillance system is only about 13.96 percent. The project does not appear to be profitable.