Question

As a financial analyst at Macleod International (MI) you have been asked to evaluate two capital investment alternatives submitted by the production department of the firm. Before beginning your analysis, you note that company policy has set the cost of capital at 15 percent for all proposed projects. As a small business, MI 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 Mi's plant. Alternative A has initial software development costs projected at $194,000, while Alternative B would cost $336,000. Software development costs would be capitalized and qualify for a capital cost allowance (CCA) rate of 30 percent. In addition, IT would hire a software consultant under either alternative to assist in making the decision whether to invest in the project for a fee of $17,000 and this cost would be expensed when it is incurred. To recover its costs, Mi's IT department would charge the production department for the use of computer time at the rate of $394 per hour and estimates that it would take 182 hours of computer time per year to run the new software under either alternative. MI owns all its computers and does not currently operate them at capacity. The information technology (IT) plan calls for this excess capacity to continue in the future. For security reasons, it is company policy not to rent excess computing capacity to outside users. If the new partial automation of production is put in place, expected savings in production cost (before tax) are projected as follows: Year UWN Alternative A 86,000 86,000 67,000 56,000 39,000 Alternative B 118,000 130,000 106,000 98,000 59,000 As the capital budgeting analyst, you are required to answer the following in your memo to the production department: a. Calculate the net present value of each of the alternatives. Which do you recommend? b. The CFO suspects that there is a high risk that the new technology will render the production equipment and this automation software obsolete after only three years. Which alternative would you now recommend? (Cost savings for Years 1 to 3 would remain the same and 4 & 5 would be zero) In your discussions with the CFA, the CIO and the head of the production department, you have pinpointed two key inputs to the capital budgeting decision: initial software development costs and the expected savings in production costs (before tax). By properly designing the contract for software development you are confident that initial software costs for each alternative can be kept in a range of plus or minus 15 percent of the original estimates. Savings in production costs are less certain because the software will involve new technology that has not been implemented before. An appropriate range for these costs is plus or minus 40 percent of the original estimates. C. Conduct sensitivity analysis to determine which of the two inputs has a greater effect on the choice between the two projects d. Conduct scenario analysis to assess the risks of each alternative in turn. What are your conclusions?

Answer 1

2 B C D E F G H I J K Note: IT Department Cost Apportioment is irrelevant will occurred whether or not any alternative is taken and opppotunity cost is occurred Alternative A Initial Investment: $194,000 Software Consultant: $17,000 Total $211,000 Alternative B $336,000 $17,000 $353,000 Alternative A Year Expected Saving Depreciation @ 30% Net Saving Post Tax @ 65% Add: Depreciation: CFAT PVF @ 15% CFAT* PVF 86000 86000 58200 40740 27800 45260 18070 29419 58200 40740 76270 70159 0.870 0.756 66321.74 53050.28 For 5 Year For 3 year 194411.37 154569.72 ($16,588.63) ($39,430.28) 3 67000 28518 38482 25013.3 28518 53531.3 0.658 35197.70 56000 19962.6 36037.4 23424.31 19962.6 43386.91 0.572 24806.61 5 39000 13973.82 25026.18 16267.017 13973.82 30240.837 0.497 15035.04 Total CFAT NPV

Font Alignment Number Styles Cells 132 A D Alternative B 106000 49392 Year Expected Saving Depreciation @ 30% Net Saving Post Tax @ 65% Add: Depreciation: CFAT PVF @ 15% CFAT* PVF 118000 130000 100800 70560 17200 59440 11180 38636 100800 70560 111980 109196 0.870 0.756 97373.91 82567.86 For 5 Year For 3 Year 303228.93 236611.26 ($49,771.07) ($116,388.74) 56608 36795.2 49392 86187.2 0.658 56669.48 98000 34574.4 63425.6 41226.64 34574.4 75801.04 0.572 4 3339.49 59000 24202.08 34797.92 22618.648 24202.08 46820.728 0.497 23278.18 Total CFAT NPV Conclusion : Both the alternatives are feasible

Ε Answer: Intial Investment is More Sensitive As Solved Below Sensitivity Analysis Case : 1 Initial Investment Increases by 15% Revised Initial Investment: Alternative A: Alternative B: 242650 405950 Revised NPV Alternative A: Alternative B: -48238.63 -102721.07 Case 1: Saving Decrease by 15%

Case 1: Saving Decrease by 15% Alternative A Year Expected Saving Depreciation @ 30% Net Saving Post Tax @ 65% Add: Depreciation: CFAT PVF @ 15% CFAT* PVF 73100 58200 14900 9685 58200 67885 0.870 59030.43 73100 56950 47600 33150 40740 2 8518 19962.6 13973.82 32360 28432 27637.4 19176.18 21034 18480.8 17964.31 12464.52 40740 28518 19962.6 13973.82 61774 46998.8 37926.91 26438.34 0.756 0.658 0.572 0.497 46710.02 30902.47 21684.83 13144.53 Total CFAT NPV 171472.29 ($39,527.71)

Year Expected Saving Depreciation @ 30% Net Saving Post Tax @ 65% Add: Depreciation: CFAT PVF @ 15% CFAT* PVF Alternative B 3 5 117999.15 110500 90100 83300 50150 100800 70560 49392 34574.4 24202.08 17199.15 39940 40708 48725.6 25947.92 11179.4475 25961 26460.2 31671.64 16866.15 100800 70560 49392 34574.4 24202.08 111979.4475 96521 75852.2 66246.04 41068.23 0.870 0.756 0.658 0.572 0.497 97373.43 72983.74 49874.05 37876.39 20418.17 Total CFAT NPV 278525.78 ($74,474.22)

Scenario analysis:

Since NPV of both alternative is Negative it worst case scenarion only , it is advised not to accept the project