Question

TSL belongs to the telecommunication industry. They provide communication services (internet, voice, mobile and other related services) for commercial and household purposes throughout Australia. TSL has been in the business for 15 years now. It is well established and profitably running business thus far. Now they have to upgrade their infrastructure which they plan to do systematically in stages gradually over next few years. For the upgrade, they need some critical hardware components and have decided to develop them in house. In order to do so, they need to setup a plant with required machinery. TSL has already undertaken some initial exploratory study, investigating several available options. This study costed them $30,000. Finally, the management has identified two vendors with different models which suit their purpose. The first model is named “Slim Tech” and the second one is “Smart Tech”. After a careful analysis, the management has worked out the following details for the two options:

Option 1: Slim Tech production The Slim Tech machinery with its delivery and installation shall cost $1,000,000 and has an expected life of 4 years. The management estimates that they shall need additional net working capital of $25,000 for smooth running of the project. The machinery is expected to depreciate to zero on a straight-line basis with an expected salvage value of $50,000 at the end of Year 4. To save on investment costs, the management intends to use a piece of land currently being used as a car parking lot. TSL generates $200,000 a year through parking fees. TSL also requires to train its staff on the new machinery and that shall cost $50,000 in the first year. The collective cost of various components to be manufactured is estimated to be $2,000,000 in Year – 1 with an expected increase of 3% per annum each year in the associated costs. The company will also pay an ongoing maintenance fees to the vendor of $150,000 a year.

Option 2: Smart Tech Smart Tech model has an expected life of 6 years and that TSL has already worked out its overall cost using NPV method and it is estimated to be $8,000,000. The applicable tax rate is 30% and the required rate of return is 10% p.a.

Required: Evaluate the two given options and make recommendations to TSL about the model they should choose. Show all workings.

Answer 1