Compute the Payback Period and the Net Present Value [NPV] of the proposal using DeltaTel‘s normal current cost of capital and five-year life, and advise whether DeltaTel should adopt the new machine giving its existing investment criteria.
DeltaTel a subsidiary of a multinational company supplies phone services to a mid-sized community in Ghana. John, the CEO attended a trade exhibition, ‘Automated Emigrate’ in Japan. As a result, John is concerned about DeltaTel’s ability to maintain its competitive position in the Ghanaian market. Owing to deregulation in the industry, and aggressive competition, a significant number of DeltaTel’s customers have switched. John feels that if DeltaTel were to invest fully in a new state–of–the–art fiber-optics technology as well as upgrade the latest computer equipment, the loss of market share may be arrested and operating efficiency may be improved.
He contacted a leading vendor of fiber-optics systems and associated computer equipment to obtain information on operating characteristics and costs. This vendor would provide the necessary fiber-optic equipment, all associated installation costs, computer hardware, and initial software support for a total cost of GHS30,000,000.
Although powerful and flexible, the new equipment is also compact, requiring much less space than the existing equipment. In addition, the equipment will require fewer people to operate and support it. Thus, additional benefits are realized by savings in occupancy and personal support costs. The new equipment promises to be highly reliable and easy to maintain and these attributes will lead to substantial savings in maintenance and repair costs. After consultations, John had the following estimated annual cost of savings from implementing the new system.
- Occupancy costs reduction due to reduced floor space GHS 2.0 M
- Lower maintenance and repairs GHS 4.0 M
- Reduced labor costs,
fringe, benefits , and associated cost GHS 7.0 M
The new equipment should also lead to reduced levels of working capital. Because of the vastly improved reliability of the new equipment, inventories of spares and repair equipment will be minimized and the high-quality customer service will result in far fewer disputed customer accounts, so more customers will pay their bills on time. John expects a GHS 5,000,000 reduction in inventory and accounts receivables, which for simplicity of analysis occur in the first year of operating the new equipment.
In addition to the outlay costs for hardware and software, John is aware that there are likely to be substantial in-house expenses related to the installations of the new technology. The engineering and the accounting staff estimated GHS10,000,000 of one-time internal costs for implementing the new technology. For internal reporting purposes, the GHS 10,000,000 internal costs will be capitalized along with the GHS 30,000,000 purchase price when determining the investment required for the new proposal. In addition, the GHS10,000,000 costs will be amortized over the useful life of the project. It may be assumed that the GHS 10,000,000 cost is required at the same time as the GHS 30,000,000 equipment purchase is made.
The vendor of the equipment requires an annual maintenance contract of GHS1,500,000 for the computer equipment and the annual costs of maintaining and upgrading the software program are assumed to be average about GHS 2,000,000. The vendor is adamant that all the equipment will have at least 10 years of useful life if it is properly maintained. The estimated disposal price of the equipment and software program is GHS 5,000,000 at the end of five years and GHS 2,000,000 at the end of 10 years. In evaluating capital expenditures DeltaTel uses its current cost of capital and a maximum time horizon of five years. DeltaTel has 1 million ordinary shares of GHS 1.0 each currently valued at GHS 2.0. The company beta at the stock exchange is estimated at 1.5 and the average return for stocks traded on the Stock Exchange estimated to be 15% while Government T-Bills is 5%. DeltaTel is also financed with GHS 1.0 M debt capital with an after-tax interest rate of 8%.
John wishes to evaluate the proposed investment in the new technology, and requests you to review the proposal and advise on the possible purchase of the equipment.
REQUIRED:
- Compute the Payback Period and the
Net Present Value [NPV] of the proposal using DeltaTel‘s normal current cost of capital and five-year life, and advise whether DeltaTel should adopt the new machine giving its existing investment criteria.
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