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Att Corp is evaluating a capital investment in a new computer system costing $71 million, with an additional $1 million for delivery and installation. The system has a 5-year MACRS depreciation schedule, but due to the half-year convention, it will take six years to fully depreciate, with MACRS percentages of 20%, 32%, 19%, 12%, 11%, and 6%. The estimated salvage value at the end of year 6 is $3 million. The project would increase revenues by varying amounts over six years, and operating costs are projected at $67 million annually. The company’s tax rate is 40%, and its cost of capital is 8%. Changes in working capital include increases in receivables ($24 million), inventories ($2 million), and accounts payable and accruals ($4 million).

Paper For Above instruction

The investment decision undergoing consideration by Att Corp involves a comprehensive capital budgeting analysis focused on determining the viability and profitability of installing a sophisticated computer system. This analysis requires careful evaluation of initial costs, operational cash flows, tax implications, salvage value, changes in working capital, and the appropriate discount rate. The purpose of this paper is to methodically analyze these components to ascertain whether the project adds value to the company, providing a detailed quantitative framework for decision-making.

Introduction

Capital budgeting is a critical managerial process in strategic financial planning, involving the identification, evaluation, and selection of long-term investment projects. It aims to optimize resource allocation to projects that generate returns exceeding their cost of capital. In the case of Att Corp, the proposed investment in a new computer system exemplifies such an analysis, requiring precise estimation of incremental cash flows, depreciation effects, tax impacts, and project risk. The decision-making process hinges on calculating the net present value (NPV), which measures the project's contribution to shareholder value.

Assumptions and Initial Data

To facilitate the analysis, the following assumptions are outlined:

• The initial acquisition cost of the computer system is $71 million, with an additional $1 million for delivery and installation, totaling $72 million.
• The system depreciates over six years under MACRS with percentages: 20%, 32%, 19%, 12%, 11%, 6%.
• The salvage value at the end of Year 6 is $3 million.
• Annual revenue increases are projected at $94 million for years 1-3, $93 million in Year 4, and $82 million for Years 5-6.
• Operational costs are constant at $67 million annually.
• The corporate tax rate applicable is 40%.
• The company's cost of capital (discount rate) is 8%.
• Changes in working capital include an increase of $24 million in receivables, $2 million in inventories, and an increase of $4 million in accounts payable and accruals.

This comprehensive set of assumptions provides the foundation for calculating the project's cash flows and assessing its profitability.

Calculating the Initial Outflow and Operating Cash Flows

The initial cash outflow at time zero encompasses the purchase cost, installation expenses, and net working capital changes. The total capital expenditure is:

• Equipment cost: $71 million
• Delivery & installation: $1 million

Therefore, the total initial investment is $72 million. Adjustments to working capital are also considered, leading to an initial net cash outflow of:

Initial Outflow = Equipment + Installation + Increase in net working capital - Accounts payable credit

= ($72 million) + (increase in receivables and inventories net of accounts payable/accumulating to $24 million + $2 million - $4 million)

Since the increased receivables and inventories are cash outflows, while accounts payable and accruals are inflows, the net working capital increase is an initial cash outflow of ($24 million + $2 million - $4 million) = $22 million.

Thus, the total initial expenditure is $72 million + $22 million = $94 million.

In subsequent years, net operating cash flows are derived from the project's revenues, operating costs, depreciation, and taxes. The calculation involves several steps:

1. Estimate the annual revenues attributable to the new system.
2. Deduct operating costs to obtain earnings before depreciation and taxes.
3. Calculate depreciation using MACRS percentages, providing annual depreciation expenses.
4. Compute taxable income by subtracting depreciation from EBIT.
5. Calculate income taxes as 40% of taxable income.
6. Determine net income after taxes.
7. Calculate net operating cash flows as net income plus depreciation (non-cash expense).

Furthermore, at the end of Year 6, the salvage value and recovery of working capital are factored into the cash flows, including taxes on the salvage proceeds.

NPV Calculation and Sensitivity Analysis

The net present value (NPV) is computed by discounting all future cash flows to present value using the company's cost of capital, then subtracting the initial outlay. Using Excel, the NPV function facilitates this calculation, ensuring the cash flows are accurately modeled, and assumptions are flexible for sensitivity analysis.

In this scenario, a worst-case salvage value of $2 million is considered, which impacts the final cash inflows at project termination. The NPV calculation is repeated to compare outcomes, offering insights into how salvage value variations influence project viability.

Similarly, a different depreciation schedule assuming four-year depreciation (33%, 45%, 15%, 7%) is tested to understand the effect of tax depreciation law changes. This adjustment impacts the annual depreciation expenses, taxes, and ultimately, the project's NPV.

Additionally, the analysis explores operational risk by determining the maximum annual operating costs increase that would still allow the project to generate a positive NPV, employing Excel's Goal Seek function. This sensitivity analysis highlights the project’s robustness against cost fluctuations.

Finally, the Internal Rate of Return (IRR) is calculated by solving for the discount rate at which the NPV equals zero, providing a measure of the project's profitability independent of the company's cost of capital.

Conclusion

The detailed capital budgeting analysis underscores the critical importance of accurate forecasting, tax considerations, depreciation methods, and sensitivity analyses in evaluating large capital projects. For Att Corp, the decision to proceed hinges on whether the calculated NPV is positive under various scenarios. If the NPV remains positive, the project adds value; if negative under certain conditions, reconsideration is necessary.

Overall, this detailed quantitative framework ensures that management makes informed, data-driven decisions aligned with shareholder interests and long-term strategic goals.

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