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Calculating Payback and NPV of an investment proposal

Company A plan considering adopting new equipment

Initial software support total cost : $30,000,000

One time internal cost for implementing new Tech(including operating and maintenance personnel cost: $10,000,000

Internal cost will be capitalized along with the $30,000,000 purchases price when determining investment required for new proposal. In addition, $10,000,000 internal costs will be amortized over the life of the project.

Anuual maintance contract (for computer equipment): $1,500,000
Equipment useful life: 10 year

Anuual maintance contract (for upgrading software): $2,500,000

Annual cost of savings may occur after implementing new system(cash inflow) :
1. reduction in occupancy cost : $2Mil
2. Lower maintenance and repair cost $4Mil
3. Reduced labor cost, fringe benefits, and associated overhead $7Mil
4. reduction in inventory and accounts receivable: $5,000,000

disposal price of equipment and software program: 5,000,000 (at the end of 5 years, discount rate : 16% ) . company A does it investment evaluation on a pretax basis.

Required:

1. What is the payback period for the proposal?

2. Calculate the net present value of the proposal assuming Company A's normal assumptions of a 16% cost of capital and five year life. Should company A adopt the new equipment given its existing investment criteria?

3. Scott White(manager ) has read an article that argues that many companies are rejecting proposals because either the discount rate is too high or the time period over which the benefits are considered is too short. He believes that Acme should use a 10% discount rate and evaluate benefits over a 10-year period (n=10, i=10%). Prepare some comments for White on the effect of making these changes in the net present value calculations.

Solution Preview

The attached excel file has the calculations. Let me know if you have any questions.

1. What is the payback period for the proposal?

We make the cash flow statement (this is in the attached file). Payback period is the time taken to recover the initial investment. The initial investment is $35 million. From the cumulative cash flows we see that at the end of three years $8 million is still to be recovered. In year 4 the cash flow is $9 million. The fraction of year needed to recover 8 million in year 4 is 8/9=0.89.
The payback period is 3.89 years

2. Calculate the net present ...

Solution Summary

The solution explains how the payback period and the NPV should be calculated. It also explains how the discount rate should be determined and the impact on the decision of changing the discount rate

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