Question

Question 4 (20 marks)

T&A is one of the leading companies in fashion and design. The company has annual revenue of $2 billion and 12,000 employees. Currently, T&A’s information systems handle hundreds of thousands of transactions each day and they could no longer keep pace with the company's growth. For many years the company has relied on more than five information systems, all of which are outdated. Since these information systems are not fully integrated, the finance staff need a lot of time and effort in generating consolidated financial statements each month. Besides, they spend a lot of time in preparing financial analysis because it requires manual effort to gather all the necessary data. The company wants to acquire a new enterprise resource planning (ERP) system that could integrate all the business functions and processes. Ideally, the new ERP system links with a business intelligence software module that allows ad hoc multidimensional data analysis.

Suppose you are the Chief Financial Officer of the company. You are asked to present a business case for acquiring a new ERP system in the upcoming meeting. Specifically, you need to compare the economic feasibility analyses of two new ERP systems, system A and B, and provide a recommendation to the company. Assume the useful life is 7 years for both systems and the cost of capital (or annual discount rate) is 6% for the company. The company’s required rate of return for any investment is 10%. The following data are provided for your evaluation.

The one-time investment costs are cash outflows which happen on day one of the projects. Except the depreciation cost, all the annual recurring costs and benefits are cash flows which happen at the end of each year. Both systems can be sold at the end of year 7 at a resale value equals to 10% of the initial investment costs. All the numbers shown are in thousands of US dollars. Although there are intangible benefits such as improvement in user satisfaction, decision making and control environment, they cannot be easily measured and quantified.

One-time investment costs Costs of acquiring computer and network hardware Costs of software Costs of preparing the site for placing equipment Costs of data conversion from old to new system Costs of training Costs of testing System A 350 200 100 30 50 40 System B 380 280 110 35 60 45 Annual recurring costs in each of the seven years Costs of hardware maintenance Costs of software maintenance Costs of information technology personnel Costs of depreciation Costs of supplies relating to the information system Costs of cyber insurance to cover system failure System A 25 20 145 110 30 10 System B 28 30 190 130 35 12 Annual recurring benefits in each of the seven years Labor cost reduction Maintenance cost reduction Increased sales System A 200 28 160 System B 250 15 200

Required:

a. For both system A and B, calculate

(i) the discounted payback period in years,

(ii) the net present value in thousands of US dollars (iii) the internal rate of return in percentage

(iv) the return on investment in percentage

(4 marks) (4 marks) (4 marks) (4 marks)

You can ignore profit tax and depreciation effect in your calculation. You must show your workings.

b. Based on the results of part (a), which system do you recommend and why? (2 marks) c. What other factor should you consider as well? (2 marks)

Answer 1

Part(a)( i)

Discounted payback period=Years before full recovery+(Unrecovered cost at the start of the year/Cashflow during the year
			System A	System B
Initial cost	770	910
Years before full recovery	5	6
Unrecovered cost at the start of the year	(770-665.55)=104.45	(910-835.95)=74.05
Cashflow during the year(6 th year for A & 7 th year for B)	111.38	113.06
Payback period=5+104.45/111.38	5.94 YEARS
Payback period=6+74.05/113.06		6.65 YEARS

WORKING NOTES & CALCULATIONS

Step-1    Calculation of initial cash outflow
Initial investmet cost	System A	System B
Cost of acquiring computer hardware and network	350	380
Cost of software	200	280
Cost of preapring the site for placing equipement	100	110
Cost of data conversion	30	35
Cost of training	50	60
Cost of testing	40	45
TOTAL COST OF INVESTMENT	770	910
Step-2 Calculation of net cashflow
Benefit	System A	System B
1-Labour cost reduction	200	250
2-Maintenance cost reduction	28	15
3-Increased sales	160	200
Total Benefit	388	465
Less: Annual expense
1-Cost of hardware maintenance	25	28
2-Cost of software maintenance	20	30
3-Cost of information technology personnal	145	190
4-Cost of depreciation	110	130
5-Cost of supplies relationg to the information system	30	35
6-Cost of cyber insurance to ocver system failure	10	12
Total annual expense	340	425
Reduce: Total annual expenses from total benefit
Net benefit of new system per year	48	40
To get Net cashflow from new system,we need to add back depreciation reduced already,beacuase it is not a cash expenditure	110	130
Net cashflow per year	158	170

Calculation of discounted payback period
Year	Cashflow		Discounted cashflow
System A (1)	System B (2)	PV factor@ 6%(3)	System A (1*3)	Cumulative discounted cashflow	System B (2*3)	Cumulative discounted cashflow
1	158	170	0.9434	149.06	149.06	160.38	160.38
2	158	170	0.8900	140.62	289.68	151.30	311.68
3	158	170	0.8396	132.66	422.34	142.74	454.41
4	158	170	0.7921	125.15	547.49	134.66	589.07
5	158	170	0.7473	118.07	665.55	127.03	716.10
6	158	170	0.7050	111.38	776.94	119.84	835.95
7	158	170	0.6651	105.08	882.02	113.06	949.00
Salvage value 10% of initial investment cost	770*10%=77	910*10%=91	0.6651	51.21	933.23	60.52	1009.53
TOTAL	933.23		1009.53

Part(a)(ii)

Calculation of Net present value
	System A	System B
Total of cumulative cash inflow	933.23	1009.53
Less:Initial cost of investment	770	910
NPV	163.23	99.53

Part(a)(iii)

Internal Rate of Return
	System A	System B
Let us assume discount rate @ 15%	15%	15%
Annuity factor for 7 Year   (A)	4.160	4.160
Discount rate of the 7th year	0.3759	0.3759
Cashflwo per year               (B)	158	170
Salvage value	77	91
Discouted cashflow for 7 years (Ax B)	657.35	707.27
Discounted cashflow of salvage value	28.94715	34.21027
Total cashflow	686.29	741.48
Less:Initial investment cost	770	910
NPV	-83.71	-168.52
Now IRR can be calculated as follows
6% + (NPV @ 6%/(933.23-686.29))*(15-6)	6%+(163.23/246.93)*9
			12%
6% + (NPV @ 6%/(1009.53-741.48))*(15-6)		6%+(99.53/268.04)*9
		9.34%
IRR	12%	9.34%

Part(a)(iv)

Return of Investment
Initial cash out flow	770.00	910.00
Net benefit per year* 7 yeas(48*7)or(40*7)	336	280
Return on investment	0.44	0.31

Part(b)

Based on the calculation in part (a) it is better to select System A as it gives higher NPV than the System B

Part(c)

The other factors should be considered are ,the desired return of the company , Return on Investmene& discounted payback period ,return of company is 10% but system B can provide only 9.34% but the system A provides 12%.In case of Return on Investmene& discounted payback period , system A performs better than System B,Hence company should go for System A