Question

Disfrutar Travel Agency is considering two different computer systems: the Standard T2 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 T2		Custom Travel
Annual revenues	$360,000		$450,000
Annual operating costs	180,000		240,000
System investment	540,000		530,000
Project life	5 years		5 years

Assume that the cost of capital for the company is 12 percent.

The present value tables provided in Exhibit 19B.1 and Exhibit 19B.2 must be used to solve the following problems.

Required:

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

NPV (Standard T2 System) = $__________

NPV (Custom Travel) = $___________

The NPV calculations imply that the Custom Travel system would be chosen because it has the larger NPV.

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

Discount factor for Standard T2 System = __________

Discount factor for Custom Travel System = __________

The discount factors imply that the IRR for the Custom Travel System is equal to the IRR for the Standard T2 system. Thus, the IRR signals that the Custom Travel System is equal to the Standard T2 System. Yet, the Custom Travel System is better than the Standard T2 system because it has the larger NPV and thus, increases firm value more.

Answer 1

1	Net present value=Present value of cash inflow-Investment cost
	Cash inflow=Annual revenues-Annual operating costs
	Discount rate=Cost of capital=12%
	Standard T2:
	Cash inflow=360000-180000=$ 180000
	Present value of cash inflow=Cash inflow*PVA of $1 at 12% for 5 years=180000*3.605=$ 648900
	Net present value=648900-540000=$ 108900
	Custom Travel:
	Cash inflow=450000-240000=$ 210000
	Present value of cash inflow=Cash inflow*PVA of $1 at 12% for 5 years=210000*3.605=$ 757050
	Net present value=757050-530000=$ 227050
2	Discount factor for Standard T2 System=Investment cost/Cash inflow=540000/180000=3
	Discount factor for custom travel System=Investment cost/Cash inflow=530000/210000=2.524
	Lower discount factor results in higher IRR
	The discount factors imply that the IRR for the Custom Travel System is more than the IRR for the Standard T2 system. Thus, the IRR signals that the Custom Travel System is better than the Standard T2 System. Yet, the Custom Travel System is better than the Standard T2 system because it has the larger NPV and thus, increases firm value more