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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 of project
$2,500,000
Depreciation method
Straight-line
Salvage value
$0
Residual value (sales price at end of project)
$475,000
Tax rate (ordinary and capital gains tax)
35%
Incremental annual revenues in year 1
$525,000
Incremental annual expenses in year 1
$205,000
Working capital required at time of investment (t=0)
$175,000
Working capital as percentage of revenue each year
12.0%
Cost of capital
10%
Economic life
10 years
Requirements:
Write a letter to the president of the company explaining whether the company should acquire the computer system. Utilize both NPV and IRR. Assume that the initial $525,000 in annual revenues will grow at an 8% annual rate and that the initial $205,000 in annual expenses will grow at a 5% annual rate. The growth starts in year 2 from year 1, i.e. the revenue is year 2 is $567,000, etc. Working capital is released at the end of the project.
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