Question

As the manager of the pension fund, you are frequently targeted by software companies peddling investment simulation software. You have finally narrowed down your choice to two applications. You need to analyze the options by calculating NPV, IRR, and Payback Period based on their purchase price and savings to your company over time. Your staff has prepared a cash-flow table to help you. Year zero shows the purchase price of each application, and the figures listed for years 1-3 represent the savings to the company in successive years.

Year	Application I	Application II
0 (today)	-$1.5 million	-$1 million
1	$0.8 million	$0.5 million
2	$0.7 million	$0.24 million
3	$0.3 million	$0.6 million

You are considering three possible scenarios.

Question 7: If the payback period is two years, which application should be selected?

Question 8: If the required rate of return is 15 percent, which application should be selected?

Question 9: If the selection criterion is IRR, which application should be selected?

Respond to questions 7, 8, and 9 above by submitting a single, integrated report that shows your supporting data and calculations. Finally, provide a recommendation and rationale for purchasing either Application I or Application II.

Submit your Basic Capital Budget Analysis Report and Calculations to the dropbox below. Be sure to show your calculations in Excel and provide a narrative analysis in PowerPoint. Your narrative analysis should include your recommendation and rationale for purchasing either Application I or Application II.

Another one of your responsibilities as CFO is to determine the suitability of new and current products. Your CEO has asked you to evaluate Android01. That task will require you to combine data from your production analysis from Project 2 with data from a consultant's study that was done last year. Information provided by the consultant is as follows:

initial investment: $120 million composed of $50 million for the plant and $70 million net working capital (NWC)

yearly expenses from year 1 to year 3: $30 million

yearly revenues from year 1 to year 3: $0

yearly expenses from year 4 to year 10: $55 million

yearly expected revenues from year 4 to year 10: $95 million

yearly expenses from year 11 to year 15: $60 million

yearly expected revenues from year 11 to year 15: $105 million

You are to calculate NPV using the “expected values”. The actual cash flow may be variable (risky) and that is the reason why the discount rate is greater than the riskless rate.

This concludes the information provided by the consultant.

You also have the following information:

Assume that both expenses and revenues for a year occur at the end of the year. NWC pays the bills during the year, but has to be replenished at the end of the year.

Android01 is expected to cannibalize the sales of Processor01 while also reducing the variable costs for the production of Processor01. From years 4 to 10, revenues are expected to fall by $5M, whereas variable costs will go down by $1 million. Processor01 is to be phased out at the end of the 10th year.

At the end of the 15th year, the plant will be scrapped for a salvage value of $10 million. NWC will be recovered.

Question 10: Calculate the expected cash flows from the Android01 project based on the information provided.

Question 11: Calculate the NPV for a required rate of return of 6.5 percent. Also calculate the IRR and the Payback Period.

Before starting your calculations, review the following materials on NPV, IRR and Payback Period.

Answer 1

Question 7:

We calculate the cumulative cash flow for application 1:

Application 1
Year	Application I	Cumulative cash flow
0	-1.5	-1.5
1	0.8	-0.7
2	0.7	0
3	0.3	0.3

From the column 3, cmulative cash flow can see that the payback for this application I is 2 years

Now, we calculate the payback for application 2:

Application 2
Year	Application II	Cumulative cash flow
0	-1	-1
1	0.5	-0.5
2	0.24	-0.26
3	0.6	0.34

Here the exact payback period = 2 +0.26/0.6 = 2.43 Years

We would select application 1 since it has a lower payback period and also staisfies the requiremt of payback to be 2 years.

Question 8:

Here we calculate the IRR

Year	Application I	Application II
0	-1.5	-1
1	0.8	0.5
2	0.7	0.24
3	0.3	0.6
IRR	11.36%	15.63%

Since the required rate is 15%, we select Application II the IRR is greater than 15%

Question 9: We select the application II as per the IRR rule.