Diana Deall Ltd is considering the purchase of new technology costing $700,000, which it will fully finance with a fixed interest loan of 10% per annum, with the principal repaid at the end of 4 years.
The new technology will permit the company to reduce its to reduce its labour costs by $250,000 a year for 4 years, and the technology may be depreciated for tax purposes by the straight-line method to zero over the 4 years. The company thinks that it can sell the technology at the end of 4 years for $40,000.
The technology will need to be stored in a building, currently being rented out for $35,000 a year under a lease agreement with 4 yearly rental payments to run, the next one being due at the end of one year. Under the lease agreement, Diana Deall Ltd can cancel the lease by paying the tenant (now) compensation equal to one year's rental payment plus 10%, but this amount is not deductible for income tax purposes.
This is not the first time that the company has considered this purchase. Twelve monthsago, the company engaged Fairgo Consultants, at a fee of $25,000 paid in advance, to conduct a feasibility study on savings strategies and Fairgo made the above recommendations. At the time, Diana Deall did not proceed with the recommended strategy, but is now reconsidering the proposal.
Diana Deall further estimates that it will have to spend $30,000 in 2 years' time overhauling the technology. It will also require additions to current assets of $40,000 at the beginning of the project, which will be fully recoverable at the end of the fourth year.
Diana Deall Ltd's cost of capital is 12%. The tax rate is 30%. Tax is paid in the year in which earnings are received.
REQUIRED:
(a) Calculate the net present value (NPV), that is, the net benefit or net loss in present value terms of the proposed purchase costs and the resultant incremental cash flows.
[HINT: As shown in the text-book, it is recommended that for each year you calculate the tax effect first, then identify the cash flows, then calculate the overall net present value.]
(b) Should the company purchase the technology? State clearly why or why not.