Net present value of of the investment, Financial Management

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Air Manchester (AM) is a new airplane manufacturer. It is considering investing in a software package, e.g. SAS, which would make its daily operations more efficient. The package costs £50,000. If the company buys the package, this will lead to yearly cost savings (prior to taxes and depreciation) of £20,000 during 4 years. The package has an economic lifetime of 4 years, and has no value at the end of its lifetime. It is depreciated according to the straightDline depreciation method (i.e. an equal amount is depreciated each year).

Prior to making the investment, AM needs to conduct some additional tests to assess the productivity and usability of the IT package. These tests will be performed by a specialised consultant that charges £4,000 (to be paid at time t=0). Five years ago the company has also spent £5,000 on a software system that will be discontinued when the new system is implemented. Moreover, the company needs to add net working capital of £1,000 immediately. This working capital can be recovered in full at the end of the software life.

The tax rate is 40% and the nominal discount rate for the investment is 10%. The yearly inflation rate is 2%. Consider initially that the entire project is financed with equity.

(a) Should AM proceed with the investment? Please provide calculations to motivate your answer.

(b) A senior executive of AM argues that this investment should be evaluated by looking at its payback period. How would you explain him/her the shortcoming of using payback period instead of NPV? Illustrate your answer using this specific investment case (i.e., use relevant figures for AM to illustrate your point).

(c) Would your results differ had you used real rather than nominal values? Why (not)? You don't need to reDdo the calculations, just provide a motivation for your answer.

(d) We assume in this problem that the new software is entirely financed by equity. Assume now that the software is partly financed by debt. Would the NPV of the investment increase or decrease, everything else equal? Justify your answer (you don't need to present the calculations, just comment on how the change in financing would affect NPV).

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