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

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

1. In Question #5, the CFO is concerned that a change in technology might make the new systems obsolete after three years. If this occurs and you only obtain three years of cost savings (as per Figure 1 above) and no salvage value, which alternative (if any), would you now recommend?

2. In Question #6, the vendors of both systems have indicated that they are working on a new generation of robotics which they expect will totally eliminate the function of the current generation of equipment. If they are able to do this, they would be willing to repurchase the current systems for the following amounts:

Answer 1

Consultant fee will not be included in the NPV calculation as it is a sunk cost.

System A NPV:

PV of tax shield on CCA:

C (cost) = 2,500,000; d (CCA rate) = 30%; Tc (tax rate) = 26%; k (cost of capital) = 18%; n (life of project) = 3

PV of tax shield = C.d.Tc*(1+0.5*k)/[(k+d)*(1+k)] = 2,500,000*30%*26%*(1+0.5*18%)/[(18%+30%)*(1+18%)] = 375,264.83

System B NPV:

PV of tax shield on CCA:

C (cost) = 4,000,000; d (CCA rate) = 30%; Tc (tax rate) = 26%; k (cost of capital) = 18%; n (life of project) = 3

PV of tax shield = C.d.Tc*(1+0.5*k)/[(k+d)*(1+k)] = 4,000,000*30%*26%*(1+0.5*18%)/[(18%+30%)*(1+18%)] = 600,423.73

Conclusion: For a 3 year project life, both systems will have a negative NPV so neither of them can be accepted.