As a financial analyst for ABC Co. you have been asked to evaluate two capital investment opportunities submitted by the production department of the firm. Before beginning your analysis, you note that the company has set the cost of capital at 15 percent for all proposed projects. ABC Co. pays corporate taxes at the rate of 35 percent.
The proposed capital project calls for developing new computer software to facilitate partial automation of production in the Company’s plant. Alternative A has initial development costs projected at $185,000. Alternative B would cost $320,000. These software development costs would be capitalized and would be depreciated on a straight line basis over 5 years. In addition, the Company would hire a software consultant under either alternative to assist in making the decision whether to invest for a fee of $16,000 and this cost would be expensed when it is incurred.
To recover its costs, ABC Co.’s Information Technology department would charge the production department for the use of the computer time at a rate of $375 per hour. It estimates that it would take 182 hours of computer time per year to run the software under either alternative. ABC Co. owns all its computers and does not currently operate them at capacity. The Company intends to have excess capacity into the future. For security purposes it does not rent out excess capacity.
If the new partial automation of production is put in place, expected savings in production cost (before tax) are projected as follows:
Year 1 Alternative A Alternative B
1 $82,000 $112,000
2 $82,000 $124,000
3 $64,000 $101,000
4 $53,000 $93,000
5 $37,000 $56,000
Scenario 1:
As the capital budgeting analyst, you are required to answer the following:
What is the net present value of each alternative? Which project would you recommend and why. (show your calculations)
What is the Internal Rate of Return (IRR) for each alternative? Which alternative would you recommend and why.
The Company believes there is a possibility that even newer technology could render the production equipment and this new automation software obsolete after only three years. What would the NPV of each alternative be in this case. Which alternative would you recommend and why ( cost savings for years 1 to 3 remain unchanged). What would IRR be for each alternative? Show all calculations and assumptions.
The Engineering department believes it could develop a way to bypass this entire process by the end of year 3. In this case salvage values for the equipment would be $50,000 at the end of year 3, $35,000 at the end of year 4, and zero after 5 years. Should the engineering department develop the solution and remove the equipment before the five years are up? Which alternative should be removed and why. Show all calculations & assumptions.
Scenario 2:
Assume that the company decides that due to the risk of obsolescence the cost of capital should be set at a rate of 30% for this project. For the five year projection only determine what NPV & IRR are for Alternatives A & B. How would that affect your recommendations & why.
Scenario 3:
The Company believes that corporate tax rates will increase in the future after 2 years to a rate of 40% and remain at that level for the remaining 3 years. For the five year projection only determine what NPV & IRR are for Alternatives A & B. How would that affect your recommendations and why. Assume the cost of capital is 15%.