Question

As a financial advisor at RedHat International (RHI), you have been asked to evaluate two capital investment alternatives submitted by the shipping department. Before beginning your analysis, you note that company policy has set the minimum desired rate of return at 18% for all proposed projects. You also learn that the corporate tax rate is 26%.

The proposed capital project calls for the shipping department to fully automate a warehouse using one of two different advanced robotics systems. System A will incur development costs of $2,500,000. System B will a cost $4,000,000 to develop. Both systems will be capitalized and amortized using a CCA rate of 30%. In addition, the firm believes that Net Working Capital will rise by $50,000 at time zero and then by an additional $10,000 at the end of each year for each year that the new system is operating (except at the end of the final year of the project). This applies to both alternatives. However, all of the increase in Net Working Capital will be recovered at the end of the project.

The Shipping Department intends to hire an outside consultant at a cost of $10,000 to help it choose which of the two alternatives would be most effective. If neither alternative is financially attractive, the consultant will be expected to point this out to the company. The amount paid to the consultant will be expensed at the time it is incurred.

To recover a portion of the development cost, the shipping department intends to charge the manufacturing department for the use of computer time at the rate of $150 per hour for 50 hours per year for each year of the project. This amount will remain the same under either alternative. RHI owns all of its computer equipment, which has significant spare capacity. The company plans to maintain this spare capacity into the future. However, it is company policy not to rent spare computer capacity to outside users due to security concerns.

If the new automated robotics system is put into use, the pre-tax cost savings each year are estimated as follows:

Year	System A	System B
1	$1,500,000	$2,000,000
2	$1,200,000	$1,750,000
3	$1,000,000	$1,500,000
4	$ 950,000	$1,250,000
5	$ 900,000	$1,100,000

Figure 1

   

As the capital budgeting analyst, you are required to draft a comprehensive memo, addressed to: The Manager, Shipping Department.

1. How should you handle the $150 per hour charge for computer time charged by the shipping department to the production department? Why? Be specific.

2. How should you handle the $10,000 payment to the Consultant? Why? Be specific.

Answer 1

A Memo on the selection of Fully Operating warehousing Project.

To,

The Manager,

Shipping Department ,

Dear Sir,

Based on the financial and operational information provided , a comprehensive Capital Investment evaluation process has been done for both the alternate Option of System A and System B B.

As per the NPV analysis , we can reach to the conclusion that System A may be selected for the development of the Automated Warehouse as it has a higher NPV of $568,709 (against $333,328 of system B) and the initial investment is also lower.

Two specific considerations have been made in this analysis;

1. The $150 per hour charge for computer time has been ignored in this evaluation. There is no new incremental cost for computer capacity generation. The existing capacity will be continued to use and there is spare capacity as well. As there is no additional cost to be incurred , the proposed charge for computer time in not relevant for evaluation.

2. The otside consultant cost of $10,000 has also been excluded for evaluation process. This is a sunk cost and the peformance of any of the two projects not affected by this cost. This is not a relevant cost for evaluation.

Please refer to the detailed evaluation done to reach to the above conclusion in favor of System A..

Any input on this will be highly appreciated.

Best Regards,

XYZ

Attachment : NPV Analysis

CCA Calculation for both the systems @30%
Year	WDV System A	CCA Deduction System A	WDV System B	CCA Deduction System B
Year 1	$       2,500,000	$          750,000	$       4,000,000	$       1,200,000
Year 2	$       1,750,000	$          525,000	$       2,800,000	$          840,000
Year 3	$       1,225,000	$          367,500	$       1,960,000	$          588,000
Year 4	$          857,500	$          257,250	$       1,372,000	$          411,600
Year 5	$          600,250	$          600,250	$          960,400	$          960,40

	Calculation of NPV of System A
	Details	Year0	Year1	Year2	Year3	Year4	Year5
	Initial Investment
	Development cost	$     (2,500,000)
	Investment in Additional WC	$          (50,000)	$          (10,000)	$          (10,000)	$          (10,000)	$       (10,000)
a	Total Initial Investment	$     (2,550,000)	$          (10,000)	$          (10,000)	$          (10,000)	$       (10,000)
	Pre Tax cost savings		$       1,500,000	$       1,200,000	$       1,000,000	$       950,000	$              900,000
	Less CCA Deduction		$          750,000	$          525,000	$          367,500	$       257,250	$              600,250
	EBT		$          750,000	$          675,000	$          632,500	$       692,750	$              299,750
	Tax @26%		$          195,000	$          175,500	$          164,450	$       180,115	$                77,935
	Post Tax Income		$          555,000	$          499,500	$          468,050	$       512,635	$              221,815
	Add back CCA deduction		$          750,000	$          525,000	$          367,500	$       257,250	$              600,250
b	Cash flow from Operations		$       1,305,000	$       1,024,500	$          835,550	$       769,885	$              822,065
	Terminal Cash flow
	Return of Working capital						$                90,000
c	Total Terminal Cash flow						$                90,000

d	Total Relevant Cash flow=a+b+c	$     (2,550,000)	$       1,295,000	$       1,014,500	$          825,550	$       759,885	$              912,065
e	Discount factor @18%=1/1.18^n	1	0.847	0.718	0.609	0.516	0.437
f	PV of Cash flows =d*e=	$     (2,550,000)	$       1,096,865	$          728,411	$          502,760	$       392,101	$              398,572
g	NPV =Sum of PV of cash flows =	$         568,709
	PI =	0.23

	Calculation of NPV of System A
	Details	Year0	Year1	Year2	Year3	Year4	Year5
	Initial Investment
	Development cost	$     (4,000,000)
	Investment in Additional WC	$          (50,000)	$          (10,000)	$          (10,000)	$          (10,000)	$       (10,000)
a	Total Initial Investment	$     (4,050,000)	$          (10,000)	$          (10,000)	$          (10,000)	$       (10,000)
	Pre Tax cost savings		$       2,000,000	$       1,750,000	$       1,500,000	$   1,250,000	$           1,100,000
	Less CCA Deduction		$       1,200,000	$          840,000	$          588,000	$       411,600	$              960,400
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