Question

Roger and Serena, tennis consultants are spending all their time trying to fix their computer system, instead of hitting forehands with tennis clients. It is requiring service on a regular basis, and the consulting bills are adding up. They are frustrated with this, and have procured three bids for a new system. But as their skills relate more to forehands, they are confused about which to accept. They have hired the USFSP Cost 1 dass to analyze such. They think all the systems would have a useful life of 5 Proposal A $60.000 Proposal B $100,000 Proposal C $45.000 7,000 Initial investment in equipment Working capital needs, returned at end of project life Annual maintenance costs Salvage value at end of year 5 Consulting billing rate Additional consulting hours 20,000 1 5,000 10,000 0,000 $250 1001 1,000 11,000(a) 45,000 S250 1 50l (a) Annual maintenance costs for Proposal B escalate 20% per year due to complexity of system The computer system that is currently in use is costing Roger and Serena $25,000 per year in operating costs. It initially cost $75,000 when it was purchased 5 years ago. They have received an offer of $5,000 from a company which wants to purchase the system for parts. If Roger and Serena can purchase an efficient system, they can work additional hours for their clients (noted as additional consulting hours above). Roger and Serena bill at $500 per hour. Depreciation expense is calculated using straight line. 1. Compute the net present value and IRR of each proposal with a discount rate of 8%. 2. Compute the payback of each 3. Compute the accrual accounting rate of return (AAROR) on both a pretax and after-tax basis. As Roger and Serena are so successful on the tennis tour, their tax rate is 40% 4. Which project would you recommend and why? Include both quantitative and qualitative factors. This is your conclusion. The conclusion should be included on the "Input" tab.

Answer 1

Proposal A
Year	0	1	2	3	4	5
Initial investment	-60000
NWC introduced & recovered	-5000					5000
After-tax annual maint. Costs		-6000	-6000	-6000	-6000	-6000
Annual depn. Tax shields(60000-10000)/5*40%		4000	4000	4000	4000	4000
Salvage at end Yr.5						10000
After-tax incl. Consulting fees		15000	15000	15000	15000	15000
Common to all 3 proposals
After-tax savings in current opg. Costs(25000*(1-40%)		15000	15000	15000	15000	15000
After-tax Sale value at Yr.0(5000*(1-40%)	3000
(assuming $ 0 book value)
Net annual cash flows	-62000	28000	28000	28000	28000	43000
Cumulative payback	-62000	-34000	-6000	22000	50000	93000
Payback period=2+(6000/28000)= Yrs.	2.21
PV F at 8%(1/1.08^ Yr.n)	1	0.92593	0.85734	0.79383	0.73503	0.68058
PV at 8%	-62000	25926	24005	22227	20581	29265
NPV of the proposal	60005
IRR	38%

Proposal B
Year	0	1	2	3	4	5
Initial investment	-100000
NWC introduced & recovered	-1000					1000
After-tax annual maint. Costs		-6600	-7920	-9504	-11405	-13686
Annual depn. Tax shields(100000-45000)/5*40%		4400	4400	4400	4400	4400
Salvage at end Yr.5						45000
After-tax incl. Consulting fees(150*250*(1-40%))		22500	22500	22500	22500	22500
Common to all 3 proposals
After-tax savings in current opg. Costs(25000*(1-40%)		15000	15000	15000	15000	15000
After-tax Sale value at Yr.0(5000*(1-40%)	3000
(assuming $ 0 book value)
Net annual cash flows	-98000	35300	33980	32396	30495	74214
Cumulative payback	-98000	-62700	-28720	3676	34171	108385
Payback period=2+(26250/32396)= Yrs.	2.81
PV F at 8%(1/1.08^ Yr.n)	1	0.92593	0.85734	0.79383	0.73503	0.68058
PV at 8%	-98000	32685	29132	25717	22415	50509
NPV of the proposal	62458
IRR	27%

Proposal C
Year	0	1	2	3	4	5
Initial investment	-45000
NWC introduced & recovered	-7000					7000
After-tax annual maint. Costs(20000*(1-40%))		-12000	-12000	-12000	-12000	-12000
Annual depn. Tax shields(45000-0)/5*40%)		3600	3600	3600	3600	3600
Salvage at end Yr.5						0
After-tax incl. Consulting fees(120*250*(1-40%))		18000	18000	18000	18000	18000
Common to all 3 proposals
After-tax savings in current opg. Costs(25000*(1-40%)		15000	15000	15000	15000	15000
After-tax Sale value at Yr.0(5000*(1-40%)	3000
(assuming $ 0 book value)
Net annual cash flows	-49000	24600	24600	24600	24600	31600
Cumulative payback	-49000	-24400	200	24800	49400	81000
Payback period=1+(24400/24600)= Yrs.	1.99
PV F at 8%(1/1.08^ Yr.n)	1	0.92593	0.85734	0.79383	0.73503	0.68058
PV at 8%	-49000	22778	21091	19528	18082	21506
NPV of the proposal	53985
IRR	43%

3. Accrual a/cg. Rate of return	Prop. A	B	C
Incremental consulting fees	25000	37500	30000
Maintenance costs	-10000	16372	-20000	(11000+13200+15840+19008+22810)/5=16372
Savings in previous opg. Costs	25000	25000	25000
Depn.	-10000	-11000	-9000
1.Annual Pretax return	30000	67872	26000
Tax at 40%	-12000	-27149	-10400
2.Annual after-tax return	18000	40723	15600
3.Average investment
Beginning value+ending( salvage) value)/2	(60000+10000)/2=	(100000+45000)/2=	(45000+0)/2=
	35000	72500	22500
So, AAROR-Pretax= (1/3)	85.71%	93.62%	115.56%
AAROR- after-tax =(2/3)	51.43%	56.17%	69.33%

ANSWERS: Summary	A	B	C
1.NPV	60005	62458	53985
1. IRR	38%	27%	43%
2.Pay back,in yrs.	2.21	2.81	1.99
3.AAROR-Pretax	85.71%	93.62%	115.56%
3.AAROR-After-Tax	51.43%	56.17%	69.33%

4. Proposal B with highest NPV is recommended

as NPV considers all the cashflows involved over the entire life of the project ,The project with the greatest NPV,gives maximum increase to shareholders' wealth.

despite involving increased initial investment & increasing annual maintenance costs--

Proposal B achieves the maximum consulting hrs. also.