Question

Nu-Concepts, Inc., a southeastern advertising agency, is considering the purchase of new computer equipment and software to enhance its graphics capabilities. Management has been considering several alternative systems, and a local vendor has submitted a quote to thc company of $15,000 for the equipment plus $16,800 for software. Assume that the equipment can be depreciated for tax purposes over three years as follows: year 1, $5,000; year 2, $5,000; year 3, $5,000. The software can be written off immediately for tax purposes. The company expects to use the new machine for four years and to use straight-line depreciation for financial reporting purposes. The market for used computer systems is such that Nu-Concepts could sell the equipment for $2,000 at the end of four years. The software would have no salvage value at that time Nu-Concepts management believes that the introduction of the computer system will enable the company to dispose of its existing equipment, which is fully depreciated for tax purposes. It can be sold for an estimated $200 but would have no salvage value in four years. If Nu-Concepts does not buy the new equipment, it would continue to use the old graphics system for four more years. Management believes that it will realize improvements in operations and benefits from the computer system worth per year before taxes. Nu-Concepts uses a 10 percent discount rate for this investment and has a marginal income tax rate of 40 percent after considering both state and federal taxes. a. Prepare a schedule showing the relevant cash flows for the project. b. Indicate whether the project has a positive or negative net present value.

Answer 1

a. Schedule of Relevant Cash Flows:

| Year | Cash Inflows | Cash Outflows | Depreciation | Tax Shield | Net Cash Flow |

|------|-------------|--------------|-------------|------------|---------------|

| 0 | - | $15,000 | - | $6,000 | -$9,000 |

| 1 | $5,000 | $5,600 | $5,000 | $2,000 | -$2,600 |

| 2 | $5,000 | $5,600 | $5,000 | $2,000 | -$2,600 |

| 3 | $5,000 | $5,600 | $5,000 | $2,000 | -$2,600 |

| 4 | $2,000 | $5,600 | $- | $- | -$3,600 |

| Total| $17,000 | $37,000 | $20,000 | $12,000 | -$8,000 |

b. Calculation of Net Present Value:

NPV = -Initial Investment + Present Value of Cash Flows

NPV = -$9,000 + [$2,600/(1+0.1)^1] + [$2,600/(1+0.1)^2] + [$2,600/(1+0.1)^3] + [$3,600/(1+0.1)^4]

NPV = -$9,000 + $2,363 + $1,933 + $1,590 + $2,106

NPV = $992

Since the NPV is positive, the project has a positive net present value and would be considered a good investment for Nu-Concepts, Inc.