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Problem - 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
$1,000,000
Depreciation method for requirement a)
Straight-line
Depreciation method for requirement b)
Sum-of-Years Digits
Salvage value
$0
Residual value (Value at end of project)
$25,000
Tax rate
35%
Incremental annual revenues in year 1
$227,000
Incremental annual expenses in year 1
$77,500
Additional working capital required now and released at end of project
$10,000
Cost of capital
10%
Economic life
10 years
Requirements:
a. Write a letter to the president of the company explaining whether the company should acquire the computer system. Show your complete analysis. Utilize both NPV and IRR. Assume that the initial $227,000 in annual revenues will grow at a 6% annual rate each year ($240,620 in year 2, etc.) and that the initial $77,500 in annual expenses will grow at a 5% annual rate each year ($81,375 in year 2, etc.).
b. Redo this analysis above using sum-of-years digits depreciation method. What happens to the results and would you change your recommendation?
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