A firm is considering purchasing a computer system. The following data has been collected:

Cost of system is $120,000. The firm will pay for the computer system in year 0.

Project life: 6 years

Salvage value in year-0 (constant) dollars: $15,000

Depreciation method: five-year MACRS

Marginal income-tax rate = 40% (remains constant over time)

Annual revenue = $145,000 (year-0 constant dollars)

Annual expense (not including depreciation) = $82,000 (year-0 constant dollars)

a) If the general inflation rate f is 5% during the project period (which will affect all revenues, expenses, and the salvage value but not depreciation), determine the cash flows in actual dollars.

b) Now assume the firm will borrow the entire $120,000 at 9% interest to be repaid in 2 annual payments. The debt interest paid and the principal repayment should not be changed by the inflation rate. Lending agencies set the interest rate of borrowing to account for the inflation rate. Calculate the effects of borrowing and include the debt interest paid and the principal repayment into the income statement and cash flow statement. Do this exactly as you did in Chapter 10, but leave the other elements (eg, annual revenue, annual expense, depreciation, salvage value) unchanged from part (a). Determine the cash flows in actual dollars with borrowing.

c) The inflation-free interest rate i' is 13%. Use the inflation-free interest rate and the average general inflation rate to calculate the market interest rate. Compute the present worth of the cash flow from part (b) using the market interest rate. Based on the present worth calculation, should the firm purchase the computer system?