In 2011, the Top Company, Inc. is considering the purchase of its first integrated computer system. The company manufactures corrugated paper, which is used for various purposes including making boxes. The company has been in business since 1990, incorporated in 1996, had achieved annual sales of $2,000,000 in 2010, and has the reputation of a very aggressive and competent competitor. Without the computer, Top Company’s sales are expected to stay constant in nominal terms at $2,000,000 in each of the next five years.
The purchase price of the new computer system is $400,000. The system will provide all customer service representatives with on-line access to customer information, inventory and production files and will provide for electronic billing and bill payment. The cost of installation and freight-in is $50,000, paid for in time zero and capitalized with the cost of the computer. The computer has a depreciation life of four years and the company plans to depreciate the equipment and associated capitalized expenses to zero using the MACRS 4-year schedule. The expected life of the project is five years.
The historical and current information that management has about the project and its expected and historical costs are as follows: The company has been working with the EDS Company for the last eight months to develop an assessment of its computer needs. EDS has already been paid $25,000 for its services. The Top Company has agreed to pay EDS a consulting fee of $10,000 at the end of each of the three years for their assistance in making the computerization process a successful and learning experience for the company if the company goes forward with the computer project. Necessary software development and training cost at the end of each of the first three years of operation will total $80,000 per year. These costs will be expensed when incurred. These costs will be included in the manufacturing overhead cost pool and allocated to various products on the basis of direct labor hours.
The expected operating benefits of the computer system are numerous. First, management expects customer service to improve, a factor that is estimated to produce an expected increase in annual sales of $200,000. Furthermore, management expects cost of goods sold on all sales to decline from 45 percent of sales to 40 percent of sales as a direct result of operating efficiencies attributable to the computer system. (Assume that depreciation expense for the new computer system is not included in cost of goods sold.) Management believes that the current supervisor of administrative services, a person who is being paid $40,000 per year, has the capacity to supervise the computer system operation. The supervision of the computer system is expected to take 20 percent of the supervisor’s time. Management expects that normal salary increases for this person would average five percent per year over the life of the computer. One new employee will be hired (assume at the end of the first year) as a result of the computerization project. This person is responsible for performing all technical support operations and will be paid $45,000 per year.
Management believes that both accounts receivable and accounts payable will decline, due to the electronic collection and bill payment aspects of the computer software. Accounts receivable are expected to decline from 30 percent of sales to 25 percent of sales while accounts payable are expected to decline from its current level of 9 percent of sales to 6 percent of sales. These changes will impact the net working capital investment for both existing and new sales. Management expected these changes in working capital as a percentage of sales to happen at the end of the first year of the computer operation. Management expects no other changes in current asset or current liability management that could be attributed to the computer system.
An aspect of the project is the fact that the computer system vendor has offered to repurchase the system from The Top Company at the end of five years. The vendor has offered a price of $50,000 for the old system. As part of the offer of the certain price of the old equipment, management had to agree to use the vendor’s annual maintenance program, which cost $20,000 per year. The cost of the maintenance will be accounted for as period costs which will be expensed each year.
Management hired a consultant last year that had, for $20,000, informed the company that the appropriate after-tax nominal opportunity cost of capital to use in the analysis of all cash flows associated with computerization projects is 12 percent. Management knew its current cost of borrowed funds was 9 percent and that 50 percent of the project would be financed with debt. The Top Company’s tax rate was expected to be 40 percent in each of the next five years.
Answer the following questions, using the net present value model where appropriate:
1. Are there any sunk costs in this project description? Explain.
2. What are the incremental effects of the computer project on the company’s required working capital investment?
3. What are the expected incremental effects of the computer project on total operating cash flows of the firm?
4. Putting your answers to items 1-3 together with all other relevant facts, assess whether management should go forward with the computer project.
5. Explain to management why the interest cost of borrowed funds was/was not included in your cash flow estimates for the project.
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