Cornerstones of Cost Management 2nd Edition by Don Hansen ,Maryanne Mowen

Exercise 14

Advanced Technology, Payback, NPV, IRR, Sensitivity Analysis
Gina Ripley, president of Dearing Company, is considering the purchase of a computer-aided manufacturing system. The annual net cash benefits and savings associated with the system are described as follows:

The system will cost $9,000,000 and last 10 years. The company's cost of capital is 12 percent.
Required:
1. Calculate the payback period for the system. Assume that the company has a policy of only accepting projects with a payback of five years or less. Would the system be acquired?
2. Calculate the NPV and IRR for the project. Should the system be purchased-even if it does not meet the payback criterion?
3. The project manager reviewed the projected cash flows and pointed out that two items had been missed. First, the system would have a salvage value, net of any tax effects, of $1,000,000 at the end of 10 years. Second, the increased quality and delivery performance would allow the company to increase its market share by 20 percent. This would produce an additional annual net benefit of $300,000. Recalculate the payback period, NPV, and IRR given this new information. (For the IRR computation, initially ignore salvage value.) Does the decision change? Suppose that the salvage value is only half what is projected. Does this make a difference in the outcome? Does salvage value have any real bearing on the company's decision?