Question

As a financial analyst for ABC Co. you have been asked to evaluate two capital investment opportunities submitted by the production department of the firm. Before beginning your analysis, you note that the company has set the cost of capital at 10 percent for all proposed projects. ABC Co. pays corporate taxes at the rate of 30 percent.

The proposed capital project calls for developing new computer software to facilitate partial automation of production in the Company’s plant. Alternative A has an initial cost projected at $370,000. Alternative B would cost $640,000. These software costs would be capitalized and would be depreciated on a straight line basis over 5 years. For tax purposes Capital Cost Allowance (CCA) would be calculated in the same manner as depreciation. In addition, the Company would hire a software consultant under either alternative to assist in making the decision whether to invest for a fee of $150,000 and this cost would be expensed when it is incurred.

To recover its costs, ABC Co.’s Information Technology department would charge the production department for the use of the computer time at a rate of $500 per hour. It estimates that it would take 364 hours of computer time per year to run the software under either alternative. ABC Co. owns all its computers and does not currently operate them at capacity. The Company intends to have excess capacity into the future. For security purposes it does not rent out excess capacity.

If the new partial automation of production is put in place, expected cash flow savings in production cost (before tax) are projected as follows:

Year 1                        Alternative A                       Alternative B          

   1                              $164,000                              $224,000     

   2                              $164,000                              $248,000

3                                $128,000                              $202,000

4                                $106,000                              $186,000

5                                $74,000                                $112,000

Scenario 1:

As the capital budgeting analyst, you are required to answer the following:

What is the net present value of each alternative? Which project would you recommend and why. (show your calculations)

What is the Internal Rate of Return (IRR) for each alternative? Which alternative would you recommend and why.

The Company believes there is a possibility that even newer technology could render the production equipment and this new automation software obsolete after only three years resulting in a terminal loss in years 4 & 5. What would the NPV of each alternative be in this case. Which alternative would you recommend and why ( cost savings for years 1 to 3 remain unchanged). What would IRR be for each alternative? Show all calculations and assumptions. Would there ever be any circumstance where this option could be justified? (Hint consider l.R.R.)

The Engineering department believes it could develop a way to bypass this entire process by the end of year 3. In this case salvage values for the equipment would be $100,000 at the end of year 3, $70,000 at the end of year 4, and zero after 5 years. Should the engineering department develop the solution and remove the equipment before the five years are up? Which alternative should be removed and why. Show all calculations & assumptions.

Scenario 2:

Assume that the company decides that due to the risk of obsolescence the cost of capital should be set at a rate of 20% for this project. For the five year projection only determine what NPV & IRR are for Alternatives A & B. How would that affect your recommendations & why.

Scenario 3:

The Company believes that corporate tax rates will increase in the future after 2 years to a rate of 35 % and remain at that level for the remaining 3 years. For the five year projection only determine what NPV & IRR are for Alternatives A & B. How would that affect your recommendations and why. Assume the cost of capital is 10%.

                                                                                                                                                                                                               

                               

Answer 1

1. NPV Calculations

For Alternative A

Year	EBDT	Dep	EBT	Tax	EAT	Add Dep	PV Factor @15%	PV
1	164000	74000	90000	27000	63000	137000	0.869565	119130.4
2	164000	74000	90000	27000	63000	137000	0.756144	103591.7
3	128000	74000	54000	16200	37800	111800	0.657516	73510.31
4	106000	74000	32000	9600	22400	96400	0.571753	55117.01
5	74000	74000	0	0	0	74000	0.497177	36791.08

Total PV	388140.5
Cost	370000
NPV	18140.52

For Alternative B

Year	EBDT	Dep	EBT	Tax	EAT	Add Dep	PV Factor @15%	PV
1	224000	128000	96000	28800	67200	195200	0.869565	169739.1
2	248000	128000	120000	36000	84000	212000	0.756144	160302.5
3	202000	128000	74000	22200	51800	179800	0.657516	118221.4
4	186000	128000	58000	17400	40600	168600	0.571753	96397.6
5	112000	128000	-16000	-4800	-11200	116800	0.497177	58070.24

Total PV	602730.8
Cost	640000
NPV	-37269.2

2. Alternative A can be selected, since it has positive and more NPV than B.

3. IRR

	A	B
Year	Flow	Flow
0	-370000	-640000
1	137000	195200
2	137000	212000
3	111800	179800
4	96400	168600
5	74000	116800
IRR	17%	12%

4. Alternate A can be selected, since it has more IRR

5. NPV for A

Year	EBDT	Dep	EBT	Tax	EAT	Add Dep	PV Factor @15%	PV
1	164000	74000	90000	27000	63000	137000	0.869565	119130.4
2	164000	74000	90000	27000	63000	137000	0.756144	103591.7
3	128000	74000	54000	16200	37800	111800	0.657516	73510.31
4	0	74000	0	0	0	96200*	0.571753	55002.66
5	0	74000	0	0	0	96200*	0.497177	47828.4

* add tax saved of 22200 to dep of 74000 since there is loss.

Total PV	399063.5
Cost	370000
NPV	29063.5

NPV for B

Year	EBDT	Dep	EBT	Tax	EAT	Add Dep	PV Factor @15%	PV
1	224000	128000	96000	28800	67200	195200	0.869565	169739.1
2	248000	128000	120000	36000	84000	212000	0.756144	160302.5
3	202000	128000	74000	22200	51800	179800	0.657516	118221.4
4	0	128000	0	0	0	166400**	0.571753	95139.74
5	0	128000	0	0	0	166400**	0.497177	82730.21

** add tax saved of 38400 to dep of 128000 since there is loss.

Total PV	626133
Cost	640000
NPV	-13867

6. IRR

	A	B
Year	Flow	Flow
0	-370000	-640000
1	137000	195200
2	137000	212000
3	111800	179800
4	96200	166400
5	96200	166400
IRR	19%	14%

7. Alternate A can be selected, since it has more IRR