As a financial advisor at RedHat International (RHI), you have been asked to evaluate two capital investment alternative
Posted: Wed Jul 06, 2022 6:27 pm
As a financial advisor at RedHat International (RHI), you havebeen asked to evaluate two capital investment alternativessubmitted by the shipping department. Before beginningyour analysis, you note that company policy has set the minimumdesired rate of return at 16% for all proposedprojects. You also learn that the corporate tax rate is22%.
The proposed capital project calls for the shipping departmentto fully automate a warehouse using one of two different advancedrobotics systems. System A will incur development costsof $2,400,000. System B will cost $3,800,000 todevelop. Both systems will be capitalized and amortizedusing a CCA rate of 20%. In addition, the firm believesthat Net Working Capital will rise by $40,000 at time zero and thenby an additional $10,000 at the end of each year for each year thatthe new system is operating (except at the end of the final year ofthe project). This applies to bothalternatives. However, all of theincrease in Net Working Capital willbe recovered at the end of the project.
The Shipping Department intends to hire an outside consultant ata cost of $10,000 to help it choose which of the two alternativeswould be most effective. If neither alternative isfinancially attractive, the consultant will be expected to pointthis out to the company. The amount paid to theconsultant will be expensed at the time it is incurred.
To recover a portion of the development cost, the shippingdepartment intends to charge the manufacturing department for theuse of computer time at the rate of $150 per hour for 60 hours peryear for each year of the project. This amount willremain the same under either alternative. RHI owns allof its computer equipment, which has significant sparecapacity. The company plans to maintain this sparecapacity into the future. However, it is companypolicy not to rent spare computercapacity to outside users due to security concerns.
If the new automated robotics system is put into use, thepre-tax cost savings each year areestimated as follows:
Year
System A
System B
1
$1,400,000
$2,000,000
2
$1,200,000
$1,650,000
3
$1,100,000
$1,450,000
4
$ 975,000
$1,200,000
5
$ 950,000
$1,100,000
Figure 1
As the capital budgeting analyst, you are required to draft acomprehensive memo, addressed to: The Manager, Shipping Department,answering the following questions:
System A
System B
End of Year 3
$600,000
$600,000
End of Year 4
$300,000
$300,000
End of Year 5
0
0
Cost savings for the years the systemsare in use will remain as shown in Figure 1 above and the impact onNet Working Capital will remain as stated up to the point that theequipment is withdrawn from service (with all working capitalrecovered at the end of the last year of service). Ifthe vendors do manage to develop the new generation of equipment,should the shipping department purchase the current generation andthen sell back to the manufacturer when the new systems arereleased? If so, what would be the optimal year tosalvage the equipment? Be specific.
The proposed capital project calls for the shipping departmentto fully automate a warehouse using one of two different advancedrobotics systems. System A will incur development costsof $2,400,000. System B will cost $3,800,000 todevelop. Both systems will be capitalized and amortizedusing a CCA rate of 20%. In addition, the firm believesthat Net Working Capital will rise by $40,000 at time zero and thenby an additional $10,000 at the end of each year for each year thatthe new system is operating (except at the end of the final year ofthe project). This applies to bothalternatives. However, all of theincrease in Net Working Capital willbe recovered at the end of the project.
The Shipping Department intends to hire an outside consultant ata cost of $10,000 to help it choose which of the two alternativeswould be most effective. If neither alternative isfinancially attractive, the consultant will be expected to pointthis out to the company. The amount paid to theconsultant will be expensed at the time it is incurred.
To recover a portion of the development cost, the shippingdepartment intends to charge the manufacturing department for theuse of computer time at the rate of $150 per hour for 60 hours peryear for each year of the project. This amount willremain the same under either alternative. RHI owns allof its computer equipment, which has significant sparecapacity. The company plans to maintain this sparecapacity into the future. However, it is companypolicy not to rent spare computercapacity to outside users due to security concerns.
If the new automated robotics system is put into use, thepre-tax cost savings each year areestimated as follows:
Year
System A
System B
1
$1,400,000
$2,000,000
2
$1,200,000
$1,650,000
3
$1,100,000
$1,450,000
4
$ 975,000
$1,200,000
5
$ 950,000
$1,100,000
Figure 1
As the capital budgeting analyst, you are required to draft acomprehensive memo, addressed to: The Manager, Shipping Department,answering the following questions:
System A
System B
End of Year 3
$600,000
$600,000
End of Year 4
$300,000
$300,000
End of Year 5
0
0
Cost savings for the years the systemsare in use will remain as shown in Figure 1 above and the impact onNet Working Capital will remain as stated up to the point that theequipment is withdrawn from service (with all working capitalrecovered at the end of the last year of service). Ifthe vendors do manage to develop the new generation of equipment,should the shipping department purchase the current generation andthen sell back to the manufacturer when the new systems arereleased? If so, what would be the optimal year tosalvage the equipment? Be specific.