Question

As a financial analyst at Delhi Systems you have been asked to evaluate two capital alternatives submitted by the production department of the firm. Before beginning you analysis. As a small business, Delhi pays corporate taxes at the rate of 35%. The proposed capital project calls for developing new computer software to facilitate partial automation of production in Delhi’s plant. Alternative A has initial software development costs estimated at $185,000, while Alternative B would cost $330,000. Software development costs would be capitalized and qualify for a capital cost allowance (CCA) rate of 30%. In addition, IT would hire a software consultant under either alternative to assist in making the decision whether to invest in the project for a fee of $17,000 and this cost could be expensed when it is incurred. To recover its costs, Delhi’s IT department would charge the production department for the use of computer time at the rate of $390 per hour and estimates that it would take 182 hours of computer time per year to run the new software under any alternative. Delhi owns all of its own computers and does not currently operate them at capacity. The Information Technology (IT) plan calls for this excess capacity to continue in the future. For security reasons, it is company policy not to rent excess computing capacity to outside users. Today, stock in Delphi trades at $55.01 on the TSX. Delhi has a beta of 1.6. The market risk premium historically has been around 4.6% and the estimate of the risk free rate is 2.4%. Delhi’s last dividend was $2.04 and some analysts estimate that it will grow at 5% indefinitely.

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

Year	Alternative A	Alternative B
1	$86,000	$121,000
2	77,000	130,000
3	68,000	98,000
4	57,000	97,000
5	41,000	59,000

Calculate NPV

?

Answer 1

Note:

The cost of equity representing the required rate of return to discount NPV can be calculated both by using Capital Asset Pricing Model (CAPM) and also Dividend Growth Model.

Cost of Equity under CAPM = 9.76%

Cost of Equity under Dividend Growth Model.= 8.89%

While each of the models have its own advantages and dis-advantages, for capital budgeting decisions, cost of equity under CAPM is widely used. Also in the question, Cost of equity under CAPM is higher than Dividend Growth Model. Thus, a higher rate can be used to discount the future cash-flows on a conservative purposes.

Workings:

Workings:

Recommendation:

Net Present Value (NPV) of Alternative A = $26,859

Net Present Value (NPV) of Alternative B = $5,439

Both the alternatives has positive NPV. However, since the Net Present Value (NPV) of Alternative A is higher, Alternative A is recommended.

Workings:

Note:

1. The software consultant cost to be hired for $17,000 under either alternative to assist in making the decision whether to invest in the project is not considered for NPV computation as the same is a sunk cost and is incurred for both alternatives and does not impact or influence the future cash-flows

2. The recovery costs of $390 per hour by the IT department on the production department for the use of computer time to run the new software is just an inter-department charge/revenue. This does not generate any cash-flow for the company and hence not considered for NPV computation.