Scenario Steps to Completion 7. The company can purchase new planning software f

Question

Scenario Steps to Completion 7. The company can purchase new planning software for $3,600. The software (asset) has a two-year life, will produce a savings of $600 in the first year and $4,200 in the second year. The discount rate is 15%. Calculate the project's payback and discounted payback period assuming steady cash flows. Also calculate the project's NPV and IRR. Should the project be funded? In light of the previous information provided, is the 15% discount rate justified. Explain your answer. Concept Check: Payback analysis is the first step in project evaluation. The calculation enables you to understand if you can simply cover the investment within a certain time period. When doing Discounted Payback analysis or NPV analysis, a discounting rate is used to reduce future cash flows to a present value. The discount rate can be determined in many ways; existing cost of capital, projected cost of capital, desired return rate, etc as long as you justify what you wish to use for discounting cash flows and are consistent in your application evaluation will be easier. Helpful Hint: IRR is discovered when you calculate an NPV where the result is zero (or as close to zero as you can get); this is an iterative process of adjusting the discount rate until you arrive at zero for an NPV. The best thing to do is first calculate NPV and see how far away from zero you are – you can then increase or decrease the discount rate until your NPV = zero. Sue has another vexing problem she has been encountering with regard to capital investments. She has competing investments and has looked at them from several different perspectives and would like your input.

Explanation / Answer

Cash flows in

year 0: -3600

year 1: +600

year 2: +4200

Cumulative cash flows in

year 0:-3600

year 1:-3600+600=-3000

year 2:-3000+4200=1200

For calculating payback, the last year where cumulative cash flows is negative is year 1

hence, payback=1+3000/4200=1.71 years

Discounted cash flows in

year 0: -3600

year 1: 600/1.15=521.739

year 2: 4200/1.15^2=3175.80

Cumulative discounted cash flows in

year 0: -3600

year 1: -3600+600/1.15=-3078.26

year 2: -3078.26+4200/1.15^2=97.54

For calculating discounted payback, the last year where cash flows was negative is year 1

hence, discounted payabck=1+3078.26/3175.8=1.97 years

So, NPV=CF0+CF1/(1+r)+CF2/(1+r)^2

=-3600+600/(1+r)+4200/(1+r)^2

=-3600+600/1.15+4200/1.15^2=97.54

IRR is the value of rate at which NPV=0

Hence, 0=-3600+600/(1+r)+4200/(1+r)^2

=>r=16.67%

IRR=16.67%

As IRR is more than discount rate, project should be funded

As NPV is more than 0, project should be funded

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