Frederick Machine Works (FMW) manufactures machine parts for aircraft auxiliary

Question

Frederick Machine Works (FMW) manufactures machine parts for aircraft auxiliary systems. The company is evaluating the purchase of a new suite of inventory and quality management system software. Specifics regarding the potential purchase: • The SW system will require a payment now of $500,000 • Additional hardware (servers and storage) will cost an additional $150,000. • The SW will be depreciated over four years • The hardware will be depreciated over six years • The SW system will save FCW $100,000 in year 1 and $125,000 per year for the rest of its useful life. • Annual software licensing and maintenance equals 18% of the purchase price of the SW. • Additional system capabilities will generate revenue of $120,000 per year in years 1-4 and $100,000 per year thereafter. • FCW's tax rate is 35% and it uses a cost of capital of 9%.

a) Develop a scheule to compute the annual after-tax cash flows and the NPV and IRR of the project. Is it acceptable?

b) Assume the SW system has an 8-year life. Update your schedule from part a to include the additional two years and compute the NPV and IRR of the project . Is the project acceptable?

c) Comment on the impact of an additional two years useful life on the project assessment. How should management accountants use this type of analysis and information to make better decisions?

Explanation / Answer

SW system Purchase cost 500000 Life of SW system 4 years Additional hardware $150,000 Life of hardware 6 years SW system saves 1 year 100000 2-4 years 125000 Annual software Licencing & maintainence 90000 Additional System generates revenue 1-4 years 125000 4-6 years 100000 Initial cash outflow 500000+150000 650000 Depreciation on SW machine 125000 Depreciation on additional software $25,000 IRR Year Revenue of SW machine Revenue for Add. Hardware Total Revenue Annual software cost Deprecition A Income Before tax Tax Income After taxB CashFlow after tax A+B Discount rate 9% Discounted cash flow Discount factor 5% Discounted cash flow Discount factor 5.6% Discounted cash flow 0 -650000 1 -650000 1 -650000 1 -650000 1 100000 125000 225000 -90000 ($150,000) ($15,000) ($15,000) $0 $150,000 0.9174 137614.7 0.9524 142857.1 0.9470 $142,045.45 2 125000 125000 250000 -90000 ($150,000) $10,000 $3,500.00 $6,500 $156,500 0.8417 131722.9 0.9070 141950.1 0.8968 $140,341.63 3 125000 125000 250000 -90000 ($150,000) $10,000 $3,500.00 $6,500 $156,500 0.7722 120846.7 0.8638 135190.6 0.8492 $132,899.27 4 125000 125000 250000 -90000 ($150,000) $10,000 $3,500.00 $6,500 $156,500 0.7084 110868.5 0.8227 128752.9 0.8042 $125,851.58 5 100000 100000 -25000 $75,000 $26,250.00 $48,750 $73,750 0.6499 47932.44 0.7835 57785.05 0.7615 $56,161.98 6 100000 100000 -25000 $75,000 $26,250.00 $48,750 $73,750 0.5963 43974.72 0.7462 55033.39 0.7211 $53,183.70 NPV -57040 11569.22 $483.61 No, it has negative NPV so not acceptable IRR around 5.6% IRR Year Revenue of SW machine Revenue for Add. Hardware Total Revenue Annual software cost Deprecition A Income Before tax Tax Income After taxB CashFlow after tax A+B Discount rate 9% Discounted cash flow Discount rate 7% Discounted cash flow Discount rate 6.83% Discounted cash flow 0 -650000 1 -650000 1 -650000 1 -650000 1 100000 125000 225000 -90000 ($87,500) $47,500 $16,625.00 $30,875 $118,375 0.9174 108600.9 0.9346 110630.8 0.9361 110806.9 2 125000 125000 250000 -90000 ($87,500) $72,500 $25,375.00 $47,125 $134,625 0.8417 113311.2 0.8734 117586.7 0.8762 117961.2 3 125000 125000 250000 -90000 ($87,500) $72,500 $25,375.00 $47,125 $134,625 0.7722 103955.2 0.8163 109894.1 0.8202 110419.6 4 125000 125000 250000 -90000 ($87,500) $72,500 $25,375.00 $47,125 $134,625 0.7084 95371.74 0.7629 102704.8 0.7678 103360.1 5 125000 100000 225000 -90000 ($87,500) $47,500 $16,625.00 $30,875 $118,375 0.6499 76935.63 0.7130 84399.74 0.7187 85073.4 6 125000 100000 225000 -90000 ($87,500) $47,500 $16,625.00 $30,875 $118,375 0.5963 70583.14 0.6663 78878.26 0.6727 79634.4 7 125000 125000 -90000 ($62,500) ($27,500) $0.00 ($27,500) $35,000 0.5470 19146.2 0.6227 21796.24 0.6297 22040.2 8 125000 125000 -90000 -62500 ($27,500) $0.00 ($27,500) $35,000 0.5019 17565.32 0.5820 20370.32 0.5895 20631.1 NPV -44530.7 -3739.04 -73.2 IRR=6.83% Depreciation for 8 years 500000/8 62500 Depreciation for hardware for 6 years $25,000 Negative NPV has reduced but still it is not acceptable Ans c By increasing the life of the asset NPV had a positive impact.

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