Problem - Winona Miller, president of CLJ Products, is considering the purchase of a computer-aided manufacturing system that requires an initial investment of $4,000,000 and is estimated to have a useful life of 10 years. CLJ Products' cost of capital is currently 12 percent.
The annual after-tax cash benefits/savings associated with the system are as follows:
Decrease in defective products - $100,000
Revenue increase due to improved quality - 150,000
Decrease in operating costs - 300,000
Required -
A. Calculate the payback period for the system.
Assume that the company has a policy of accepting only projects with a payback of five years or less. Should the system be purchased?
B. Calculate the NPV and the IRR for the project. Use the minus sign to indicate a negative NPV, if required.
Should the system be purchased?
What if the system purchase does not meet the payback criterion?
C. The project manager reviewed the projected cash flows and pointed out that two items had been missed. First, the system would have a salvage value, net of any tax effects, of $500,000 at the end of 10 years. Second, the increased quality would allow the company to increase its market share by 30 percent, leading to an additional annual after-tax benefit of $180,000. Given this new information, recalculate the payback period, NPV, and IRR. Use the minus sign to indicate a negative NPV, if required.
Would your recommendation change? Why?