Total cash flow







At 10 percent, it's straightforward to verify that the NPV here is $3,860, so we should go ahead and automate.

CHAPTER 10 Making Capital Investment Decisions 335

To Buy or Not to Buy

We are considering the purchase of a $200,000 computer-based inventory management system. It will be depreciated straight-line to zero over its four-year life. It will be worth $30,000 at the end of that time. The system will save us $60,000 before taxes in inventory-related costs. The relevant tax rate is 39 percent. Because the new setup is more efficient than our existing one, we will be able to carry less total inventory and thus free up $45,000 in net working capital. What is the NPV at 16 percent? What is the DCF return (the IRR) on this investment?

We can first calculate the operating cash flow. The aftertax cost savings are $60,000 x (1 - .39) = $36,600. The depreciation is $200,000/4 = $50,000 per year, so the depreciation tax shield is $50,000 x .39 = $19,500. Operating cash flow is thus $36,600 + 19,500 = $56,100 per year.

The capital spending involves $200,000 up front to buy the system. The aftertax salvage is $30,000 x (1 - .39) = $18,300. Finally, and this is the somewhat tricky part, the initial investment in net working capital is a $45,000 inflow because the system frees up working capital. Furthermore, we will have to put this back in at the end of the project's life. What this really means is simple: while the system is in operation, we have $45,000 to use elsewhere.

To finish our analysis, we can compute the total cash flows:


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