Your
firm, Wilmington Tool and Tie Corporation, is considering purchasing
four new CAD workstations for a total of $250,000 to improve
productivity by translating designs for new dies more efficiently
into finished products with fewer defects. You believe that this
investment would increase the firm's after-tax income by $60,000 per
year over a five-year period by reducing production costs. At the
end of five years, your firm plans to sell the workstations for a
total of $50,000. The amount the firm would recover when it sells
the used equipment is called the salvage value of the equipment.
You would like to evaluate this expenditure to see if it is a
good investment. To be considered worthwhile a capital expenditure
must produces at least the same rate of return on the money invested
as if the amount of the investment were invested somewhere else,
such as at a bank, at a certain rate of interest specified by the
firm.
Review the discussion of capital budgeting methods for
information system investments in Chapter 13. The following
spreadsheet shows the results of using the net present value method
for Wilmington's investment in the new CAD equipment. The total cash
flow is the sum of the additional income produced by the investment
plus any salvage value of the equipment.
To arrive at the return from the investment in today's dollars,
one must first calculate the present value of the total cash flow
from this new equipment discounted at the prevailing interest rate
for borrowing money. The initial purchase price of the equipment in
today's dollars is then subtracted from the present value of the
total cash flow from the investment to arrive at the net present
value of the investment. If the net present value for the investment
is positive, it is a worthwhile investment. If it is negative, the
investment should be rejected.
The following spreadsheet shows the results of your calculations
assuming that interest rates are 8% and that the investment is
producing $60,000 each year in additional income for the firm. Since
investments are highly sensitive to changes in interest rates and
economic conditions, you have added a sensitivity analysis to see
whether the machine tool makes a good investment under a wide range
of situations. The data table shows the impact on net present value
if the interest rate and the annual income from using the new
equipment are lower or higher than the original assumptions.
Please see "Chapter 11 Management Decision
Problem File - Chap11_MDP_Spreadsheet.xls" on Web
site.
