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Capital Budgeting

Global Technology is considering investing in a new computer system. The system would be used for all of the firm's business applications and is expected to yield the following (incremental) benefits (with all other yearly flows remaining constant):

* Additional sales revenue of $50,000 per year, given the fact that the system will be able to provide better sales support materials and optimally track cusotmer-service information.

* Utility cost savings of $70,000 per year, as the temperature control/cooling requirements of this new system are much less than the requirements of the current system.

* Inventory cost savings of $60,000 per year, as the inventory software on the new system will help Global keep better track of inventory (levels) and allow Global to order inventory Just In Time basis.

* A reduction in Bad Debt Expense of $40,000 per year, as the Accounts Receivables package for this system will help Global do a better job of analyzing credit applicants, generating invoices in a timely fashion, and collecting outstanding balances (due).

The purchase price for this new system is $400,000. In addition, Global will have to pay for transportation/delivery costs will be $5,000 and installation/set-up costs will run about $25,000.

The useful life of the machine is estimated to be 3 years. At the end of the useful life, Global should be able to realize a (gross) salvage value of $30,000, although the firm incur costs of $10,000 to realize the salvage value. All yearly savings associated with the new system are assumed to last throughout the asset's useful life, starting in year 1.

Global currently has the following capital structure:
Preferred Stock......10%
Common Equity......50%

The cost of debt is 10 percent; the cost of preferred stock is 15 percent and the cost of equity is 20 percent.

Using the information provided, determine the Net Present Value of this proposed project. Should Global pursue this project? Why or Why not?

Verify Answer:

Revenue $50K
Utilities $70K
Inventory $60K
Bad Debt $40K
Total Inflows = $220K

Cost of new system = $400K
Transportation cost = $ 5k
Set-up cost = $25K
Total Outflows = $430K

Useful life of machine 3 years
Salvage value of maching = $30K
Salvage value incur cost = ($10K) ?????
Net Salvage Value = $20K

WACC = Debt 40% Cost of Debt = 10%
Preferred Stock 10% Cost of Pref. Stock = 15%
Common Stock 50% Cost of common stock = 20%

WACC = Wd Kd(1-t) + Wps Kps + Wcs Kcs
WACC = .40(10%) + .10 (15%) + .50 (20%)
WACC = 4.0% + 1.5% + 10%
WACC = 15.50% or discount rate

NPV = NCFo + NCF1/(1+r)^1 + NCF2/(1+r)^2 + NCF3/(1+r)^3 + Salvage Value/(1+r)^3

NPV = ($430,000)+$220,000/1.1550+$220,000/(1.1550)^2 + $220,000/(1.1550)^3
+ $20,000/(1.1550)^3

NPV = (430,000) + $190,476.19 + $164,914.45 + $142,783.07 + $12,980.28

NPV=$81,153.99 ; yes, pursue project since NPV>0, which yields a positive cash flow over 3 years.

Solution Preview

Your answer is correct.

For salvage value, the realized value is ...

Solution Summary

The solution explains how to calculate the NPV of a project.