Question

4. The Andy Aghastli Company (AAC) designs a range of eye-catching fluorescent tennis clothing. The designers have always hand-drawn and painted their new fashion ranges. The owner, Mr Aghastli, is considering purchasing a new computer-aided design (CAD) package to allow his designers to create their designs on computers. The CAD project is expected to generate cost savings by improving productivity. Also, AAC can submit electronic templates of its latest designs to the manufacturers of its fashion ranges, which would also generate significant savings. The up-front hardware and software cost to AAC is estimated at $300,000. The computers and software have a 5-year useful life. After that, the technology will be obsolete and will have no salvage value. The CAD project is expected to save AAC approximately $88,000 (after tax) per annum.

   REQUIRED:

   Advise Mr Aghastli on the acceptability of the CAD proposal, applying the following capital budgeting methods:

   1. Net Present Value,

   2. Internal Rate of Return.

Answer 1

The acceptability of the project is to be tested using the methods
of evaluation that consider time value of money.
The two methods usually used are:
1] NPV [Net present value], and
2] IRR [internal rate of return]
For evaluation using the above methods we need the cost of
capital of our firm.
Suppose the COC of our firm is 10%, then the evaluation of the
proposal under the two methods would be as under:
1] NPV:
NPV is the excess of PV of cash inflows over the initial investment
when the cash inflows are discounted using the cost of capital.
So, NPV = -300000+88000*(1.1^5-1)/(0.1*1.1^5) =	$                 33,589
The NPV is positive and it means that the project is viable and can
be implemented.
Positive NPV means that the return to creditors and stockholders
and their principal contributions have been paid back, leaving a
residual surplus equal to the NPV, which is to be taken by the
stockholders. Thus, positive NPV suggests addition to shareholders
wealth.
2] IRR:
IRR is the internal rate of return provided by the cash flows from
the project. It tells what return the project earns considering
its cash flows.
Using a financial calculator, the IRR is 14.29%. As this rate of return
is more than the cost of capital of 10%, the project can be accepted.