Frederick Machine Works (FMW) manufactures machine parts for aircraft auxiliary

Question

Frederick Machine Works (FMW) manufactures machine parts for aircraft auxiliary systems. The company is evaluating the purchase of a new suite of inventory and quality management system software. Specifics regarding the potential purchase: • The SW system will require a payment now of $500,000 • Additional hardware (servers and storage) will cost an additional $150,000. • The SW will be depreciated over four years • The hardware will be depreciated over six years • The SW system will save FCW $100,000 in year 1 and $125,000 per year for the rest of its useful life. • Annual software licensing and maintenance equals 18% of the purchase price of the SW. • Additional system capabilities will generate revenue of $120,000 per year in years 1-4 and $100,000 per year thereafter. • FCW's tax rate is 35% and it uses a cost of capital of 9%.

a) Develop a scheule to compute the annual after-tax cash flows and the NPV and IRR of the project. Is it acceptable?

b) Assume the SW system has an 8-year life. Update your schedule from part a to include the additional two years and compute the NPV and IRR of the project . Is the project acceptable?

c) Comment on the impact of an additional two years useful life on the project assessment. How should management accountants use this type of analysis and information to make better decisions?

Explanation / Answer

Computation of annual cash flows for Six years:

1st year 2nd year 3rd year 4th year 5th year 6th year

Cash inflow from SW system(SWS) $100,000 $125,000 $125,000 $125,000 - -

Cash flow from Additional hardware (Add HW) $120,000 $120,000 $120,000 $120,000 $100,000 $100,000

Depreciation for SWS ($125,000) ($125,000) ($125,000) ($125,000)

Depreciation for Add HW ($25,000) ($25,000) ($25,000) ($25,000) ($25,000) ($25,000)

Licencse &Maintenance ($27,000) ($27,000) ($27,000) ($27,000) ($27,000) ($27,000)

Tax 15,050 $23,800 $23,800 $23,800 $16,800 $16,800

Profit $27,950 $44,200 $44,200 $44,200 $31,200 $31,200

Calculation of NPV:

Discounting factors 0.91743 0.84168 0.77218 0.70843 0.64993 0.59627

Present Values $25,642 $37,202 $34,130 $31,313 $20,278 $18,604

Net Present Value = $25,642 + $37,202 + $34,130 + $31,313 + $20,278 + $18,604 = 167,169

Calculation of IRR:

Cash inflows $220,000 $245,000 $245,000 $245,000 $100,000 $100,000 Discounted Cash inflows @9% $201,835 $206,212 $189,184 $173,565 $64,993 $59,627 Discounted Cash inflows @25% $176,000 $156,800 $125,440 $100,450 $32,800 $26,200 IRR = 9% +245,416/

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