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Capital Budgeting : NPV Method

Problem 1
The president of E-Games, an online gaming company, is considering the purchase of some equipment used for the development of new games. The cost is $400,000, the economic life and the recovery period are both 5 years, and there is no terminal disposal value. Annual pretax cash inflows from operations would increase by $130,000, giving a total 5-year pretax savings of $650,000. The income tax rate is 40%, and the required after-tax rate of return is 14%.

1. Compute the NPV, assuming straight-line depreciation of $80,000 yearly for tax purposes. Should E-Games acquire the equipment?
2. Suppose the asset will be fully depreciated at the end of year 5 but is sold for $25,000 cash. Should E-Games acquire the equipment? Show computations.
3. Ignore number 2. Suppose the required after-tax rate of return is 10% instead of 14%. Should E-Games acquire the equipment? Show computations.

Problem 2
The head of the oncology department of FH Research Center is considering the purchase of some new equipment. The cost is $420,000, the economic life is 5 years, and there is no disposal value. Annual cash flows from operations would increase by $140,000, and the required rate of return is 14%. There are no taxes.
1. Compute the NPV.
2. Should the research center acquire the equipment? Explain.

Solution Summary

There are two problems. Solutions to these problems depict the methodology to calculate NPV's in the given cases.

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