In: Finance
TSL belongs to the telecommunication industry. They provide
communication services (internet, voice, mobile and other related
services) for commercial and household purposes throughout
Australia.
TSL has been in the business for 15 years now. It is well
established and profitably running business thus far. Now they have
to upgrade their infrastructure which they plan to do
systematically in stages gradually over next few years. For the
upgrade, they need some critical hardware components and have
decided to develop them in house.
In order to do so, they need to setup a plant with required
machinery. TSL has already undertaken some initial exploratory
study, investigating several available options. This study costed
them $30,000. Finally, the management has identified two vendors
with different models which suit their purpose. The first model is
named “Slim Tech” and the second one is “Smart Tech”.
After a careful analysis, the management has worked out the
following details for the two options:
Option 1: Slim Tech production
The Slim Tech machinery with its delivery and installation shall
cost $1,000,000 and has an expected life of 4 years. The management
estimates that they shall need additional net working capital of
$25,000 for smooth running of the project. The machinery is
expected to depreciate to zero on a straight-line basis with an
expected salvage value of $50,000 at the end of Year 4.
To save on investment costs, the management intends to use a piece
of land currently being used as a car parking lot. TSL generates
$200,000 a year through parking fees.
TSL also requires to train its staff on the new machinery and that
shall cost $50,000 in the first year. The collective cost of
various components to be manufactured is estimated to be $2,000,000
in Year – 1 with an expected increase of 3% per annum each year in
the associated costs. The company will also pay an ongoing
maintenance fees to the vendor of $150,000 a year.
Option 2: Smart Tech
Smart Tech model has an expected life of 6 years and that TSL has
already worked out its overall cost using NPV method and it is
estimated to be $8,000,000.
The applicable tax rate is 30% and the required rate of return is
10% p.a.
Required:
Evaluate the two given options and make recommendations to TSL
about the model they should choose. Show all workings.