The CPA practice of Knape, Knape & Knape is considering investing in a complete
ID: 2653604 • Letter: T
Question
The CPA practice of Knape, Knape & Knape is considering investing in a complete small business computer system. The initial investment will be $70,000. The computer is in the 5-year MACRS category, and the firm's tax rate is 43%. The computer system is expected to provide additional revenue of $32,000 per year for the next six years, and to reduce expenses by $7,000 per year for the same period.
a) Calculate the net after-tax cash flows from this investment.
b) Calculate the net present value of the system, given that the law firm's weighted average cost of capital is 12%. Compute IRR in Excel using IRR formula.
c) Should they buy the computer system
Explanation / Answer
Initial investment = $ 70000
Using 5-year MACRS Depreciation rate,
Depreciation in Year 1 = 20%*70000 = 14000
Depreciation in Year 2 = 32%*70000 = 22400
Depreciation in Year 3 = 19.2%*70000 = 13440
Depreciation in Year 4 = 11.52%*70000 = 8064
Depreciation in Year 5 = 11.52%*70000 = 8064
Depreciation in Year 6 = 5.76%*70000 = 4032
Pre tax Cash Saving = Additional revenue + Reduce expenses
Pre tax Cash Saving = 32000 + 7000
Pre tax Cash Saving = $ 39000
a) Calculate the net after-tax cash flows from this investment.
Net after-tax cash flows = Pre tax Cash Saving *(1-tax Rate) + Depreciation* tax rate
Net after-tax cash flows in Year 1 = 39000*(1-43%) + 14000*43% = $ 28,250
Net after-tax cash flows in Year 2 = 39000*(1-43%) + 22400*43% = $ 31,862
Net after-tax cash flows in Year 3 = 39000*(1-43%) + 13440*43% = $ 28,009.20
Net after-tax cash flows in Year 4 = 39000*(1-43%) + 8064*43% = $ 25,697.52
Net after-tax cash flows in Year 5 = 39000*(1-43%) + 8064*43% = $ 25,697.52
Net after-tax cash flows in Year 6 = 39000*(1-43%) + 4032*43% = $ 23,963.76
b) Calculate the net present value of the system, given that the law firm's weighted average cost of capital is 12%. Compute IRR in Excel using IRR formula.
NPV = - 70000 + 28250/1.12 + 31862/1.12^2 + 28009.20/1.12^3 + 25697.52/1.12^4 + 25697.52/1.12^5 + 23963.76/1.12^6
NPV = $ 43,613.29
IRR in Excel using IRR formula
IRR = irr({-70000,28250,31862,28009.2,25697.52,25697.52,23963.76})
IRR = 32.91%
c) Should they buy the computer system
Yes, they should buy the computer system