Question

Managerial Accounting

Project 6 Capital Budgeting

Hi, please solve this for me. I'm having one heck of a time figuring out these answers. Please show the process on how you got these answers. Thanks!!

Carrington Co is a mid-sized financial services firm with small offices throughout the United States. Management is considering the best way to invest cash that has been set aside for technology improvements. They have narrowed their decision down to two options.

Option #1 Moving to the Cloud

Carrington would move their servers to a Cloud based system. The savings would be immediate as they can sell their old server equipment for $300,000, after applicable taxes. To move to the Cloud based system, Carrington would need to modify their current equipment and pay a onetime set up fee for a total acquisition cost of $700,000. They would also need to train their employees to use the new system and the estimate for training costs is $50,000 to be spent in the Year 1. Under this plan, Carrington would save $260,000 a year on expenses related to maintaining their own servers, and they would pay their Cloud vendor $100,000 per year in fees. Carrington will set aside $200,000 in working capital for this project and this capital will be recovered at the end of 5 years. There is no salvage value for the new equipment, but Carrington will be able to recycle the equipment for free.

Option #2 Big Data Investment

Carrington would invest in software and some hardware upgrades that will allow them to better analyze the traffic coming in to their website. Total acquisition costs for this option are estimated to be $400,000. This improved analytics capability is expected to lead to increased revenue of: $80,000 in Year 1, $120,000 in Year 2, $250,000 in Year 3, $350,000 in Year 4, and $500,000 in Year 5. The estimated cost of this obtaining this revenue will be 20% per revenue dollar related to sales staff that will analyze this data and use it to generate new client relationships. Carrington will also incur fixed costs of $10,000 per year related to software updates and hardware maintenance. Carrington will set aside $250,000 in working capital for this project and this capital will be recovered at the end of 5 years. The salvage value of the new equipment will be $9,000 at the end of 5 years.

Additional Information:

• Each option has a five year useful life.
• Carrington uses a 10% required rate of return to evaluate all of their projects.
• Acquisition costs for both projects qualify for modified accelerated depreciation (MACRS) of 50, 30, and 20% in the first three years of the project.
• Carrington is a profitable company and any income or cost savings would be taxed at Carrington’s tax rate of 21%.
• All dollar values referenced in this case are in nominal dollars. For your analysis, ignore the effect of inflation.

Assignment

Instructions: Please embed your answers inside the document after each question. If you are unsure about something, feel free to email me for guidance.

1.        Given the data provided, calculate the Payback Period, Internal Rate of Return, and NPV for your designated option.

               

2.        Good Times.

            Option #1: Due to increased demand for Cloud computing resources, Carrington’s Cloud computing fees are expected to rise 10% from Year 1 to Year 2, 6% from Year 2 to Year 3, and level off (stay the same) in Years 3-5. This increase in cost would not have happened if Carrington stayed with their old system of housing their own servers.

            Option #2: The data analytics program pays off a lot faster than expected. Revenue is projected to be $200,000 in Year 1, $250,000 in Year 2, $250,000 in Year 3, $300,000 in Year 4, and $300,000 in Year 5.

3.        Hard Times.

            Option #1: Expecting a difficult year, Carrington’s Cloud vendor decides to waive their annual fee in Year 1, but will charge Carrington $125,000 per year in Years 2-5.

            Option #2: The data analytics program pays off slower than expected. Revenue is projected to be $20,000 in Year 1, $80,000 in Year 2, $200,000 in Year 3, $500,000 in Year 4, and $500,000 in Year 5.

4.         A GREAT tax plan! Congress is proposing a new corporate tax plan that reduces the federal tax rate that Carrington pays from 21% to 15%. However, this tax plan would also do away with MACRS and replace it with straight line depreciation for tax purposes (over five years for both options).

           

            A.) Using the original estimates for your designated option, estimate the effect of this tax plan on NPV.

            B.) Next, given the uncertainty related to the effect of the proposed tax plan on future business, use a 14% required rate of return instead of the 10% rate used before in estimating the effect of the tax plan (i.e. just redo 4A).

5.         Besides the capital budgeting numbers that you’ve calculated above, what are some qualitative concerns related to accepting your designated option. List at least two. Provide a short discussion (2-3 sentences) of why each would be considered an advantage or disadvantage.

Answer 1

1.

Option 2:
Year	Cost of Equipment (A)	Working Capital (B)	Salvage Value (C )	Revenue (D)	Costs (E )	Fixed Costs (F)	Depreciation (G)	Tax Amount (H) = 21%*(D-E-F-G)	Net Profit (I) = (D-E-F-G-H)	Net Cash Flows (J) = (I+G+C+B+A)	Cumulative Cash Flows from Year 1
Year 0	$                (400,000.00)	$    (250,000.00)	$                         -	$                 -	$                 -	$                -	$                  -	$                              -	$                       -	$                 (650,000.00)	$                                   -
Year 1	$                                  -	$                      -	$                         -	$   80,000.00	$   16,000.00	$ 10,000.00	$ 200,000.00	$                              -	$     (146,000.00)	$                     54,000.00	$                     54,000.00
Year 2	$                                  -	$                      -	$                         -	$ 120,000.00	$   24,000.00	$ 10,000.00	$ 120,000.00	$                              -	$       (34,000.00)	$                     86,000.00	$                   140,000.00
Year 3	$                                  -	$                      -	$                         -	$ 250,000.00	$   50,000.00	$ 10,000.00	$    80,000.00	$                23,100.00	$         86,900.00	$                   166,900.00	$                   306,900.00
Year 4	$                                  -	$                      -	$                         -	$ 350,000.00	$   70,000.00	$ 10,000.00	$                  -	$                56,700.00	$      213,300.00	$                   213,300.00	$                   520,200.00
Year 5	$                                  -	$      250,000.00	$             9,000.00	$ 500,000.00	$ 100,000.00	$ 10,000.00	$                  -	$                81,900.00	$      308,100.00	$                   567,100.00	$                1,087,300.00

Tax Amount only if Revenue minus Costs minus Fixed Costs minus Depreciation is positive amount.

NPV

NPV(10%, Net Cash Flows for each year)

$84,882.71

IRR

IRR(Net Cash Flows for each year)

13.86%

Payback Period	We observe that the initial capital investment of $400,000 is covered between Year 3 and Year 4
Payback Period	(400000-306900)/213300	0.44
Payback Period	between 3 and 4 (3+0.44) years	3.44

2.

Option 2:
Year	Cost of Equipment (A)	Working Capital (B)	Salvage Value (C )	Revenue (D)	Costs (E )	Fixed Costs (F)	Depreciation (G)	Tax Amount (H) = 21%*(D-E-F-G)	Net Profit (I) = (D-E-F-G-H)	Net Cash Flows (J) = (I+G+C+B+A)	Cumulative Cash Flows from Year 1
Year 0	$                (400,000.00)	$    (250,000.00)	$                         -	$                 -	$                 -	$                -	$                  -	$                              -	$                       -	$                 (650,000.00)	$                                   -
Year 1	$                                  -	$                      -	$                         -	$ 200,000.00	$   40,000.00	$ 10,000.00	$ 200,000.00	$                              -	$       (50,000.00)	$                   150,000.00	$                   150,000.00
Year 2	$                                  -	$                      -	$                         -	$ 250,000.00	$   50,000.00	$ 10,000.00	$ 120,000.00	$                14,700.00	$         55,300.00	$                   175,300.00	$                   325,300.00
Year 3	$                                  -	$                      -	$                         -	$ 250,000.00	$   50,000.00	$ 10,000.00	$    80,000.00	$                23,100.00	$         86,900.00	$                   166,900.00	$                   492,200.00
Year 4	$                                  -	$                      -	$                         -	$ 300,000.00	$   60,000.00	$ 10,000.00	$                  -	$                48,300.00	$      181,700.00	$                   181,700.00	$                   673,900.00
Year 5	$                                  -	$      250,000.00	$             9,000.00	$ 300,000.00	$   60,000.00	$ 10,000.00	$                  -	$                48,300.00	$      181,700.00	$                   440,700.00	$                1,114,600.00

NPV

NPV(10%, Net Cash Flows for each year)

$140,343.35

IRR

IRR(Net Cash Flows for each year)

17.48%

Payback Period	We observe that the initial capital investment of $400,000 is covered between Year 2 and Year 3
Payback Period	(400000-325300)/166900	0.45
Payback Period	between 2 and 3 (2+0.45) years	2.45

3.

NPV

NPV(10%, Net Cash Flows for each year)

$58,451.33

IRR

IRR(Net Cash Flows for each year)

12.50%

Payback Period	We observe that the initial capital investment of $400,000 is covered between Year 3 and Year 4
Payback Period	(400000-195300)/308100	0.66
Payback Period	between 3 and 4 (3+0.66) years	3.66

4 A)  

NPV

NPV(10%, Net Cash Flows for each year)

$125,499.45

IRR

IRR(Net Cash Flows for each year)

15.56%

Payback Period	We observe that the initial capital investment of $400,000 is covered between Year 3 and Year 4
Payback Period	(400000-312060)/241230	0.36
Payback Period	between 3 and 4 (3+0.36) years	3.36

4 B)

NPV

NPV(10%, Net Cash Flows for each year)

$30,854.90

IRR

IRR(Net Cash Flows for each year)

15.56%

Payback Period	We observe that the initial capital investment of $400,000 is covered between Year 3 and Year 4
Payback Period	(400000-312060)/241230	0.36
Payback Period	between 3 and 4 (3+0.36) years	3.36