Problem:
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.
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 save the firm $700,000 per year in pretax operating costs, and the upgrade will increase the working efficiency and reduce net working capital at the beginning year by $300,000.
Showing all your work, 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 add the firm $900,000 per year in sales, while it requires an initial investment in net working capital of $300,000.
Showing all your work, what would be the NPV of Plan B? What would be the IRR of Plan B? Shall Ferengi finally choose Plan A or B?