Question

Foster Airlines is considering two different computer systems: the Standard System and the Custom Travel System. The projected annual revenues, annual costs, capital outlays, and project life for each system (in after-tax cash flows) are as follows:

	Standard System	Custom Travel
Annual revenues	$540,000	$675,000
Annual operating costs	270,000	360,000
System investment	810,000	945,000
Project life	5 years	5 years

Assume that the required rate of return for the company is 12 percent.

Required:

1. Calculate the NPV for each of the two systems (round discount factor to five decimal places and present values to the nearest dollar):

NPV (Standard System) =____ $

NPV (Custom Travel) = _____$

The NPV calculations imply that the ____  system would be chosen because it has the_______ NPV.

2. Calculate the discount factor associated with the IRR for each project (round calculated discount factor to five decimal places):

Discount factor for Standard System = ______

Discount factor for Custom Travel System = ______

Thus, given the discount factors and using the table for the present value of an annuity, we can say that the IRR for each project is between______% and_____% (round to nearest percent).

Furthermore, the discount factors imply that the IRR for the Custom Travel System is_____ the IRR for the Standard System. Thus, the IRR signals that the economic benefit of the Custom Travel System is_______ the Standard System. Yet, the economic benefit of the Custom Travel System is_______ the Standard System because it has the _______ NPV and thus, _________ firm value more.

Answer 1

NPV = - Cash Outflow + Cash Flow from year / (1+r) ^ n

Required Rate of Return =12%

Custom Travel	0	1	2	3	4	5
Annual revenues	($945,000)	$675,000	$675,000	$675,000	$675,000	$675,000
Annual operating costs		$360,000	$360,000	$360,000	$360,000	$360,000
Profit		$315,000	$315,000	$315,000	$315,000	$315,000
DCF	($945,000)	$281,250	$251,116	$224,211	$200,188	$178,739
NPV	($94,162.63)

Standard System	0	1	2	3	4	5
Annual revenues	($810,000)	$540,000	$540,000	$540,000	$540,000	$540,000
Annual operating costs		270,000	270,000	270,000	270,000	270,000
Profit		$270,000	$270,000	$270,000	$270,000	$270,000
DCF	($810,000)	$241,071	$215,242	$192,181	$171,590	$153,205
NPV	($80,710.82)

1. Calculate the NPV for each of the two systems (round discount factor to five decimal places and present values to the nearest dollar):

NPV (Standard System) =($80,710.82)

NPV (Custom Travel) = ($94,162.63)

1) The NPV calculations imply that the Standard System  system would be chosen because it has the least negative NPV.

2) IRR is the rate at which NPV is zero

For Custom Travel NPV at required rate is ($94,162.63)

IRR = Cash Flow Year /(1+R)^ n = 0

Using Trial and Error methods

Discounting Custom Travel at 15%

NPV is ($182340.90) which is further lower than at required rate of 12%

Discounting Custom Travel at 10%

NPV is $65,916 which is higher than at required rate of 10% . However for Ideal IRR NPV has to be 0

Discounting Custom Travel at 9.5%

NPV is ($851) which is Close to Ideal IRR

Similarly using this method further IDEAL IRR for 0 NPV is 9.47955%

Discounting Standard Travel at 15%

NPV is ($156,292) which is further lower than at required rate of 12%

Discounting Custom Travel at 10%

NPV is ($18167) which is lower than at required rate of 10% . However for Ideal IRR NPV has to be 0

Discounting Custom Travel at 9.5%

NPV is ($365) which is Close to Ideal IRR

Similarly using this method further IDEAL IRR for 0 NPV is 9.47955%

Hence Ideal IRR for both Travel cases is 9.47955%

2. Calculate the discount factor associated with the IRR for each project (round calculated discount factor to five decimal places):

Discount factor for Standard System =9.47955%

Discount factor for Custom Travel System =9.47955%

Thus, given the discount factors and using the table for the present value of an annuity, we can say that the IRR for each project is between9.47955%% and 9.5% (round to nearest percent).

Furthermore, the discount factors imply that the IRR for the Custom Travel System is marginally better than the IRR for the Standard System. Thus, the IRR signals that the economic benefit of the Custom Travel System is Marginally more than the Standard System. Yet, the economic benefit of the Custom Travel System is more the Standard System because it has the Better NPV and thus, adding firm value more.