Question

As a financial advisor at Minor International (MI), you have been asked to evaluate two capital investment alternatives submitted by the production department. Before beginning your analysis, you note that company policy has set the required rate of return for all new projects at 20% per year. You also learn that the corporate tax rate is 24%.

The proposed capital project calls for the IT Department to develop new computer software to facilitate partial automation of a production plant. Alternative A will incur development costs of $130,000 to create the software.   Alternative B will cost $240,000 to develop the software. Software development costs are capitalized and amortized using a CCA rate of 30%. In addition, the firm believes that Net Working Capital will rise by $5,000 at time zero and then by an additional $5,000 at the start of each year for each year that the program is operating. This applies equally to both alternatives. All the increase in Net Working Capital will be recovered at the end of the project.

The IT 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 (or if they should not invest in either of them). 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 its costs, the IT department intends to charge the production department for the use of computer time at the rate of $150 per hour for 50 hours per year. This amount will remain the same under either alternative. MI owns all its computer equipment, which has significant spare capacity. The IT department plans to maintain this spare capacity into the future. It is company policy NOT to rent spare computer capacity to outside users because of security concerns.

If the new automation process is put into use, the pre-tax cost savings each year are estimated to be as follows:

Year	Alternative A	Alternative B
1	$110,000	$185,000
2	$ 90,000	$160,000
3	$ 70,000	$ 90,000
4	$ 60,000	$ 70,000
5	$ 30,000	$ 65,000

Figure 1

   

As the capital budgeting analyst, you are required to draft a comprehensive memo, addressed to the Manager, Production Department, answering the following questions:

Calculate the NPV of each alternative using the six steps of capital budgeting and the cost savings shown in Figure 1 above. Which alternative would you recommend? Be specific and provide an explanation for you answer.

Answer 1

Alternative: A
Year	Particulars	Cash ouflows
0	Development Costs	130000
0	Initial Working Capital	5000
1 to 5	Additional Working Capital	17,700
	(Annuity Factor= 3.54)@20% =5000*3.54
1 to 5	It Department Costs	26550
	($150*50*3.54)
	Present value of cash Outflows	179250

Year	Inflows	Tax @24%	Depreciation	Tax savings	Cash inflows	PVF @ 20%	Present value
1	110000	26400	39000	7800	91400	0.89	81,607
2	90000	21600	27300	5460	73860	0.80	58,881
3	70000	16800	19110	3822	57022	0.71	40,587
4	60000	14400	13377	2675	48275	0.64	30,680
5	30000	7200	9,364	1873	24673	0.57	14,000
		1	Present value of Cash inflows				2,25,755
		2	Present value of Cash Out flows				179250
		3	Net Present Value = 1-2				46,505

Alternative: B
Year	Particulars	Cash ouflows
0	Development Costs	240000
0	Initial Working Capital	5000
1 to 5	Additional Working Capital	17,700
	(Annuity Factor= 3.54)@20% =5000*3.54
1 to 5	It Department Costs	26550
	($150*50*3.54)
	Present value of cash Outflows	289250

Year	Inflows	Tax @24%	Depreciation	Tax savings	Cash inflows	PVF @ 20%	Present value
1	185000	44400	72000	14400	155000	0.89	1,38,393
2	160000	38400	50400	10080	131680	0.80	1,04,974
3	90000	21600	35280	7056	75456	0.71	53,708
4	70000	16800	24696	4939	58139	0.64	36,949
5	65000	15600	17,287	3457	52857	0.57	29,993
		1	Present value of Cash inflows				3,64,017
		2	Present value of Cash Out flows				289250
		3	Net Present Value = 1-2				$74767

Npv is higher in alternative B therefore Alternative B is recommended