Reference no: EM132484960
The first alternative, the Terminator System, will cost $280,000. The alternative system, the Skynet System, will cost $345,000. According to the Income Tax Act, the investments are CCA Class 8 assets with a CCA rate of 20%. As the decision is being made during the 2020 tax year, use the new PV of CCA tax shield formula throughout this project. Both systems are expected to have a nine-year useful life span. The Terminator System has an expected salvage value of $15,000 and the Skynet System an expected salvage value of $32,000. Both projects will require an additional working capital investment. For the Terminator System, net working capital will increase by $10,000 at time zero and increase by further $2,000 per year over the life of the project. The system's net working capital investment will be fully recovered at the end of the system's useful life. For the Skynet System, net working capital will increase by $20,000 at time zero and increase by further $4,000 per year over the life of the project. The entire net working capital investment will be fully recovered at the end of the system's useful life. As the company lacks the internal expertise to evaluate the feasibility of each system, Strawberry Hill will hire an outside AI 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 AI 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 owns its computer systems. It is the company policy not to rent out spare computer capacity 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
The company's corporate income tax rate is 28%. The company's weighted cost of capital must be updated. The company just paid its annual dividend of $4.50 per share. The common share currently sells for $48 per share. You estimate that the company dividend will grow steadily at 5% per year for the foreseeable future. The company has 1.5 million common shares outstanding. Strawberry Hill currently has a bond issue outstanding with twelve years to maturity. The $25,000 face value bond offers a 4% semi-annual coupon. Bonds currently sell for 91.05751% of face value. The bond's yield to maturity will be used as the estimated before tax cost of debt for the company. Strawberry Hill has 3,600 of the bonds outstanding.
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 your answer.