Case material: Your company is considering replacing its old and relatively inef

Question

Case material: Your company is considering replacing its old and relatively inefficient operating system with new technology. The new technology, which will cost $2 million to purchase and install, has an estimated useful life of 3 years. If needed, the existing operating system could also remain functional for the next 3 years, but has no resale value either now or at the end of the 3 years because of its obsolescence. The new technology is expected to have a resale value equal to 25% of its original cost at the end of the 3 years If the new system is installed, management believes that sales revenues can be increased by $1,750,000 annually while cost of goods sold are expected to remain constant at 60% of sales revenues. Annual system operating costs will be S500,000 lower with the new technology than with the existing operating system. As a result of the increased sales volume, management believes that working capital needs will also increase by $225,000. Your company's tax rate is 31%, its cost of capital is 12%, and the applicable depreciation rate for tax purposes rate for the new technology is 15% Required Using the net present value (NPV) method, determine if your company should replace its operating system with the new technology Based on this information, calculate both the payback period and the internal rate of return (IRR) for the proposed project. Identify two weaknesses for each of the payback period and internal rate of return (IRR) capital budgeting criteria.

Explanation / Answer

2 weakness of IRR
a) IRR doesn't take into consideration the scale of the project|
b)Multiple IRRs occur when  cash flows alternate between negative and positive values of cash flows tTHis creates confusion

2 weakness of PAY back period
a) It doesn't take into consideration about the cash flow after the payback period..
b)It can't be used to rank between projects

T=0 T=1 T=2 T=3 Initial Investment New Technology -2,000,000 Working Capital -225,000 Total Investment -2,225,000 add Revenues 1,750,000 1,750,000 1,750,000 subtract Cost of Goods Sold 1050000 1050000 1050000 COGS = 60% of Sales subtract Annual Operating Cost -500,000 -500,000 -500,000 Cost savings subtract Depreciation 500000 500000 500000 Depreciation =( Investment in Technology -Salvage)/3 EBT 700,000 700,000 700,000 Tax = 31%* EBT 217000 217000 217000 EAT = EBT - Tax 483,000 483,000 483,000 add Depreciation 500000 500000 500000 add After Tax salvage value 0 0 345000 After Tax Salvage Value = Initial Value*0.25*(1- tax rate) Cash flow 983,000 983,000 1,328,000 Dicount Rate =12% NPV 381,564.32 (NPV Using Excel Formula = Total Investment + NPV(discount Rate, All cash flows) -2,225,000 983000 983000 1328000 IRR 21% (Excel Function IRR = (All Cash flows) -2,225,000 983000 983000 1328000 Incremental Cash Flow -1,242,000 -259,000 1,069,000 Pay Back Period Full period until recovery + Incremental Cash at Year 2/ Total Cash flow at Year 3 2.20 Years

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