As the company lacks the internal expertise to evaluate the feasibility of each system,…
As the company lacks the internal expertise to evaluate the feasibility of each system, Strawberry Hill will hire an outside Al software consultant at the cost of $25,000. The consultant will help the management team decide whether the capital project is viable and, if so, the alternative that is most financially attractive. This analysis is needed before a decision can be made.
To recover project costs, the Engineering Department proposes to rent the new Al system to other businesses at the rate of $200 per computer hour for an estimated 1,500 computer hours per year. As both systems have roughly the same productive capacity, the figures are the same for the two alternative systems. The company its computer systems. It is the company policy not to rent .out spare computer ca; icity to outside users due to competitive concerns.
If the new automation process is put into use, the pre-tax cost savings each year are estimated to be as follows. The estimated useful lifetime of the alternative systems are nine years.
Figure 1: Estimated Pre-Tax Cost Savings
Year Terminator Skynet 1 $120,000 $135,000 2 $110,000 $125,000 3 $105,000 $115,000 4 $102,000 $112,000 5 $95,000 $106,000 6 $92,000 $102,000 7 $90,000 $98,000 8 $55,000 $95,000 9 $34,000 $86,000
As the financial analyst, you are required to draft a comprehensive memo, addressed to the Chief Operations Officer, answering the following questions:
1. What is the weighted average cost of capital for the company (e.g. the discount rate used for analyzing the budget proposals)? 2. How you would account for the $25,000 payment to the Consultant? Why? Be specific. 3. How you would account for the $200 per hour charged by the IT department? Why? Be specific. 4. Calculate the NPV of each alternative using the six steps of capital budgeting and the cost savings shown in Figure 1 above. Which alternative would you recommend? Be specific and provide an explanation for you answer. 5 The COO is concerned that new technology might make the Al system obsolete after five years. If this occurs and you only obtain five years of cost savings (as per Figure 1 above), which alternative (if any), would you now recommend?
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