Final Case
Powell Corporation is considering replacing its current computer system with a new one. The computer system itself will cost $300,000 (i.e. Software and Hardware) with additional outlays for installation of $50,000 and training costs of $30,000. The new computer system will result in a net reduction of 4 Employees for a total annual salary savings of $125,000. Operating cost savings from the new computer system will be $20,000 annually. Powell Corporation expects a $35,000 increase in current assets and a $20,000 increase in current liabilities related to the new computer system. Powell Corporation assumes that the change in net working capital is an opportunity cost equal to its current cost of capital of 15%. Powell Corporation also estimates that it will be able to sell its current computer system for $75,000, which was bought 3 years ago for $200,000 and being depreciated over 4 years with a zero salvage value using the straight-line method, upon the implementation of the new computer system.
The expected life of the new computer system is four years, with an estimated salvage value of zero. The effective tax rate is 40%. The new computer will be depreciated using the straight-line method over its four-year life. All relevant cash flows are received at the end of the year (i.e. Ordinary Annuity). Assume 365 days in a year. Powell Corporation's cost of capital is 15%.
Requirements of Problem (20 Points):
1) Prepare a spreadsheet that shows your initial investment computation along with all relevant operating cash inflows/(outflows) over the four-year life of the new computer system. (6 points)
2) Compute the Payback Period (2 points).
The Payback Period =3.04 years
3) Compute the NPV (Net Present Value) (2 points).
NPV=-$23,128
4) Compute the IRR (Internal Rate of Return) (2 points).
IRR=11.96%
5) Based upon your computations in questions 2 - 4 and the fact that Management has a pre-determined payback period of 2 years for all capital expenditures, should Powell Corporation proceed with the purchase of the new computer system and Why? (5 points)
The new computer system is not the appropriate choice for Powell Corporation to purchase, because the payback period of 3.04 years is longer than pre-determined payback period of 2 years.
6) Which of the three capital budgeting techniques is better and Why? (3 points)
There is no technique perfectly alone. But compared to other two methods, I think the NPV method is better. The NPV method reports net dollars impact on the company, so it can be easier to use when allocating capital. According to the size of investment, the NPV and IRR methods may rank two programs differently. When inconsistencies arise, NPV is the preferred method. Assessing the financial impact is a more meaningful indicator for a capital-budgeting decision