Question

CASE 11.2 SUBOPTIMIZATION PROBLEM. Manson's Payroll Service consists of two pri- mary divisions-Payroll Services and Tax Services The payroll services division does very well, earning on average 18% ROI . Tax services, on the other hand, struggles earning on average only 8.5% ROI. The company's WACC is 8 %. It is year-end, and both divisions are faced with deciding whether or not to invest in new computers and software support systems. The details of the options that Payroll Services and Tax Services are looking at are in the following table.

Answer 1

A.

Payroll Services

Tax Services

Year	PV Factor @8% WACC	Proj A	Proj B	Proj A	Proj B
0	1.0000	(1,500,000)	(1,000,000)	(1,800,000)	(1,200,000)
1	0.9259	700,000	550,000	900,000	600,000
2	0.8573	600,000	300,000	700,000	500,000
3	0.7938	500,000	300,000	500,000	400,000
	NPV of CF	59,468	4,611	30,387	101,758

Projects have positive CF.

B.

			Payroll Services		Tax Services
Year	PV Factor @18% ROI	PV Factor @8.5% ROI	Proj A	Proj B	Proj A	Proj B
0	1.0000	1.0000	(1,500,000)	(1,000,000)	(1,800,000)	(1,200,000)
1	0.8475	0.9217	700,000	550,000	900,000	600,000
2	0.7182	0.8495	600,000	300,000	700,000	500,000
3	0.6086	0.7829	500,000	300,000	500,000	400,000
	NPV of CF @18%		(171,554)	(135,854)
	NPV of CF @8.5%				15,566	90,886

Tax Services Project have positive CF.

C. Payroll Services net profit after Tax is equal to new project investment. This department can make investment decision easily as far as initial investment is concerned. TAx Services NPAT is lower then initial investment. This department will not e able make initial investment on the basis of NPAT.

At 8% WACC, both projects have positive NPV. Hence both should invest in the project.

D. At WACC both projects have positive NPV. Hence its recommended to go for the investment. Payroll services may have higher return on existing business, but new investment will help them stay in business. Tax services will do better with this investment.