Study Appendix 11. The head of the corporate tax division of a major public relations firm has proposed investing $290,000 in personal computers for the staff. The useful life and recovery period for the computers are both 5 years. The firm uses MACRS depreciation. There is no terminal salvage value. Labor savings of $140,000 per year (in year-zero dollars) are expected from the purchase. The income tax rate is 35%, and the after-tax required rate of return is 25%, which includes a 5% element attributable to inflation.
1. Compute the NPV of the computers. Use the nominal required rate of return and adjust the cash flows for inflation. (For example, year 1 cash flow = 1.05 * year 0 cash flow.)
2. Compute the NPV of the computers using the nominal required rate of return without adjusting the cash flows for inflation.
3. Compare your answers in numbers 1 and 2. Which is correct? Would using the incorrect analysis generally lead to overinvestment or underinvestment? Explain.