Ferengi, Inc. is subject to an applicable corporate tax rate of 35 percent, and the weighted average cost of capital (WACC) of 12.5 percent. There is no specific time constraint on investment project payback requirements.
1. Ferengi is currently contemplating two capital investment plans. Plan A: the upgrade of an information system with an installed cost of $2,400,000. The upgrade system will be depreciated straight-line to zero over the project’s five-year life, at the end of which the system will be worth $400,000 at the market. The system upgrade will not affect sales, but will save the firm $700,000 per year in pretax operating costs; and the upgrade will increase the working efficiency and reduce the net working capital expenditure by $300,000 at the beginning year.
What is the NPV of Plan A? What is the IRR of Plan A? Should Ferengi accept or reject Plan A?
2. Instead of Plan A, Ferengi can alternatively choose Plan B: allocate the $2,400,000 capital budget to develop a new product line. The new product line will be depreciated straight-line to zero over the project’s ten-year life, at the end of which the system will be worth $100,000. The new product line will not only add the firm $830,000 per year in sales, but also add $200,000 per year in pretax operating costs; and the new project line requires an initial investment in net working capital of $300,000 at the beginning year.
What would be the NPV of Plan B? What would be the IRR of Plan B? If these two plans are mutually exclusive, shall Ferengi finally choose Plan A or B?