The success of Maryville Environmental Services depends on Mike and Tim’s capita
ID: 2658101 • Letter: T
Question
The success of Maryville Environmental Services depends on Mike and Tim’s capital investment decision. They must decide either to: (1) install a new information technology system or (2) update the existing information technology system. Each alternative offers Maryville Environmental Services advantages and disadvantages in remaining a market leader in water engineering management. Only time will tell if Mike and Tim made the right decision. Such is the case for many difficult business decisions. You need to work with Mike and Tim and help them make the best decision possible at this time with the available data.
The following conversation between Mike and Tim illustrate the challenges they face:
Mike: Tim, I’m not sure what we should do about our information technology capital investment decision. Should we simply purchase a new information technology system or update the existing system? Our software vendor no longer supports the products we use, and our hardware is very old. The competition provides higher quality consulting services than we do by leveraging information our current information technology system doesn’t provide. To remain in business and operate competitively, we must change. Yet, what is the best decision for today and for the many years to come? What are the risks in purchasing a new information technology system compared to the risks in updating the existing system?
There are a number of different tools for analyzing a capital investment decisions, but some of the simplifying assumptions built into the models trouble me. For example, how is it possible to forecast a specific increase in profitability three to six years from today, when the estimate is based on subjective data, such as, better customer information? My gut feeling is that assumptions built into the tools have a significant effect on our information technology decision.
Tim: Mike, I agree with your concerns, especially when we consider the intangibles. Can the sales team actually grow revenues and increase cash flows with the additional customer information provided by the new or updated existing information technology system?
Mike and Tim face a difficult business challenge. They must select an information technology system that offers the greatest short- and long-term benefits for Maryville Environmental Services and its workforce, and balance the benefits against the risk of changing the information technology system. The managing partners request that you evaluate two mutually exclusive investment alternatives: either to (1) purchase a new information technology system or (2) update the existing information technology system, and then make a recommendation to the managing partners. When making your recommendation, you must make explicit the many assumptions and that often comprise a capital investment decision.
Maryville Environmental Services believes they must improve their current information technology system to obtain the following potential benefits:
An efficient and effective inventory supply and contractor management system
The ability to capture more information on customer’s needs
The ability to capture and share information about engineering jobs among the engineering groups
A radio frequency identification (RFID) tracking system
A support staff that is more efficient and effective (Maryville Environmental Services offers retraining for a new position in the company to any support staff function eliminated as a result of information technology changes)
Resource consumption information must remain cost competitive
Maryville Environmental Services began operations in 1975. The company provides water management engineering services for developers, city planners, and architectural firms nationwide. Competitors view Maryville Environmental Services as the market leader in the water management systems industry. Consequently, Mike and Tim must invest in a new or updated information technology system to meet customer needs and remain a market leader.
Maryville Environmental Services’ engagements span a wide range of services. A routing engagement, for example, entails the design and engineering of residential housing development water management systems. Specific services include detailed landscape plans for rainwater drainage, and the design for fresh water flow into the development as well as the flow of wastewater back into the drainage system.
An example of a complex engagement is the design and engineering of airport water management systems. Services include the design of runway water management systems, complex and integrated water management systems for airport terminals, aircraft waste disposal systems, fire safety systems, restaurant support systems, and other facilities that serve a large population. Maryville Environmental Services partners critically supervise the construction process of all jobs. Moreover, customers appreciate the attention Maryville Environmental Services gives to every detail. Projects currently at various stages of completion include residential developments, a hospital, and an airport.
Exhibit 1 contains information related to estimated costs and savings associated with the purchase of a new information technology system.
Exhibit 2 contains information related to estimated costs and savings associated with the update of the existing information technology system.
Exhibit 1
Purchase new system
Initial Outlay
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Initial cash outflows
Hardware
$1,600,000
Software
1,000,000
Training
200,000
Site preparation
200,000
Initial systems design
1,500,000
Conversion
750,000
Total initial cash outflow
5,250,000
Recurring cash outflows
Hardware expansion
$ 0
$260,000
$300,000
$340,000
$380,000
$420,000
Software
0
150,000
200,000
225,000
250,000
275,000
Systems maintenance
60,000
120,000
130,000
140,000
150,000
160,000
RFID tags and scanner
500,000
450,000
450,000
400,000
200,000
100,000
Communication charges
100,000
160,000
180,000
200,000
220,000
240,000
Networking charges
300,000
420,000
490,000
560,000
630,000
700,000
Total cash outflows
960,000
1,560,000
1,750,000
1,865,000
1,830,000
1,895,000
Cash inflows
Clerical and general overhead cost
60,000
800,000
700,000
600,000
800,000
1,000,000
Working capital
100,000
300,000
500,000
1,000,000
800,000
800,000
Profits from growing existing services
0
900,000
900,000
1,200,000
1,400,000
1,500,000
Profits from growing sales
0
700,000
800,000
1,200,000
1,600,000
2,000,000
Total cash inflows
160,000
2,700,000
2,900,000
4,000,000
4,600,000
5,300,000
Cash inflows less cash outflows
(800,000)
1,140,000
1,150,000
2,135,000
2,770,000
3,405,000
Less income taxes
272,000
(387,600)
(391,000)
(725,900)
(941,800)
(1,157,700)
Cash inflows (outflows) net of tax
(528,000)
752,400
759,000
1,409,100
1,828,200
2,247,300
Depreciation tax shield
297,500
297,500
297,500
297,500
297,500
297,500
Net cash inflows (outflows)
(230,500)
1,049,900
1,056,500
1,706,600
2,125,700
2,544,800
Exhibit 2
Update existing system
Initial Outlay
Year 1
Year 2
Year 3
Initial cash outflows
Hardware
$200,000
Software
300,000
Training
200,000
Site preparation
100,000
Initial systems design
1,000,000
Conversion
200,000
Total initial cash outflow
2,000,000
Recurring cash outflows
Hardware expansion
$ 0
$0
$200,000
Software
0
100,000
100,000
Systems maintenance
60,000
100,000
125,000
RFID tags and scanner
500,000
300,000
150,000
Communication charges
100,000
160,000
180,000
Networking charges
100,000
200,000
250,000
Total cash outflows
760,000
860,000
1,005,000
Cash inflows
Clerical and general overhead cost
500,000
400,000
300,000
Working capital
300,000
300,000
200,000
Profits from growing existing services
600,000
500,000
900,000
Profits from growing sales
600,000
400,000
800,000
Total cash inflows
2,000,000
1,600,000
2,200,000
Cash inflows less cash outflows
1,240,000
740,000
1,195,000
Less income taxes
(421,600)
(251,600)
(406,300)
Cash inflows (outflows) net of tax
818,400
488,400
788,700
Depreciation tax shield
226,667
226,667
226,667
Net cash inflows (outflows)
1,045,067
715,067
1,015,367
Required:
1) Compute the payback period for the two alternatives. Discuss the advantages and disadvantages of using the payback period to evaluate capital investment decisions. Based on the results of the calculated payback period, which investment would you recommend that Mike and Tim pursue?
2) Assuming the company requires an 8% return from capital investments determine the net present value of the two alternatives. Discuss the advantages and disadvantages of using the net present value method to evaluate capital investment decisions. Based on the results of the calculated net present value, which investment would you recommend that Mike and Tim pursue?
3) Perform net present value calculations using the original cash flows but modifying the company’s required return from capital investment decisions. First, assume the required rate of return is 6%. Next, assume the required rate of return is 10%. How would these modifications affect the recommendation that you would make to Mike and Tim?
4) Assuming the company has a hurdle rate for capital investments of 8% determine the internal rate of return for the two alternatives. Discuss the advantages and disadvantages of using the internal rate of return method to evaluate capital investment decisions. Based on the results of the calculated internal rate of return, which investment would you recommend that Mike and Tim pursue?
5) Discuss any significant assumptions that are required to use the capital investment tools that you used above. Are there any concerns that you would want to bring to Mike and Tim’s attention related to these assumptions?
6) What is your final recommendation to Mike and Tim?
Exhibit 1
Purchase new system
Initial Outlay
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Initial cash outflows
Hardware
$1,600,000
Software
1,000,000
Training
200,000
Site preparation
200,000
Initial systems design
1,500,000
Conversion
750,000
Total initial cash outflow
5,250,000
Recurring cash outflows
Hardware expansion
$ 0
$260,000
$300,000
$340,000
$380,000
$420,000
Software
0
150,000
200,000
225,000
250,000
275,000
Systems maintenance
60,000
120,000
130,000
140,000
150,000
160,000
RFID tags and scanner
500,000
450,000
450,000
400,000
200,000
100,000
Communication charges
100,000
160,000
180,000
200,000
220,000
240,000
Networking charges
300,000
420,000
490,000
560,000
630,000
700,000
Total cash outflows
960,000
1,560,000
1,750,000
1,865,000
1,830,000
1,895,000
Cash inflows
Clerical and general overhead cost
60,000
800,000
700,000
600,000
800,000
1,000,000
Working capital
100,000
300,000
500,000
1,000,000
800,000
800,000
Profits from growing existing services
0
900,000
900,000
1,200,000
1,400,000
1,500,000
Profits from growing sales
0
700,000
800,000
1,200,000
1,600,000
2,000,000
Total cash inflows
160,000
2,700,000
2,900,000
4,000,000
4,600,000
5,300,000
Cash inflows less cash outflows
(800,000)
1,140,000
1,150,000
2,135,000
2,770,000
3,405,000
Less income taxes
272,000
(387,600)
(391,000)
(725,900)
(941,800)
(1,157,700)
Cash inflows (outflows) net of tax
(528,000)
752,400
759,000
1,409,100
1,828,200
2,247,300
Depreciation tax shield
297,500
297,500
297,500
297,500
297,500
297,500
Net cash inflows (outflows)
(230,500)
1,049,900
1,056,500
1,706,600
2,125,700
2,544,800
Explanation / Answer
Exhibit 1 Purchase new system N YEAR 0 1 2 3 4 5 6 A Net cash inflows (outflows)including initial outlay -5,250,000 -230,500 1,049,900 1,056,500 1,706,600 2,125,700 2,544,800 Cumulative Cash Flow -5,250,000 -5,480,500 -4,430,600 -3,374,100 -1,667,500 458,200 3,003,000 Present Value (PV) of Cash Flow: (Cash Flow)/((1+i)^N) i=Discount Rate N=Year of Cash Flow Assuming i=8%=0.08 SUM PV=A/(1.08^N) Present Value (PV) of Cash Flow: -5,250,000 -213,426 900,120 838,684 1,254,402 1,446,716 1,603,656 580,151 NET PRESENT VALUE 580,151 Based on NPV, Purchase new system is recommended Assuming i=6%=0.06 SUM PV=A/(1.06^N) Present Value (PV) of Cash Flow: -5250000 -217453 934407 887058 1351787 1588447 1793984 1088230 NET PRESENT VALUE 1088230 Assuming i=10%=0.1 SUM PV=A/(1.1^N) Present Value (PV) of Cash Flow: -5,250,000 -209,545 867,686 793,764 1,165,631 1,319,892 1,436,473 123,901 NET PRESENT VALUE 123,901 INTERNAL RATE OF RETURN 10.58% (Using IRR function of excelover the net cash flow PaybackPeriod=Period at which Cumulative cashflow =NIL Payback Period=4+(1667500/2125700) 4.8 Years Paybackperiod does not take into account Time value of money It does not differentiate between receipt of money earlier or later within paybackperiod Based on PaybackPeriod , Update existing systemis recommended Update existing system N YEAR 0 1 2 3 A Net cash inflows (outflows)including initial outlay -2000000 1,045,067 715,067 1,015,367 Cumulative Cash flows -2000000 -954,933 -239,866 775,501 Assuming i=8%=0.08 SUM PV=A/(1.08^N) Present Value (PV) of Cash Flow: -2000000 967654.6296 613054.6982 806031.0611 386740 NET PRESENT VALUE 386740 Assuming i=6%=0.06 SUM PV=A/(1.06^N) Present Value (PV) of Cash Flow: -2000000 985912 636407 852522 474841 NET PRESENT VALUE 474841 Assuming i=10%=0.1 SUM PV=A/(1.1^N) Present Value (PV) of Cash Flow: -2000000 950060.9091 590964.4628 762860.2554 303886 NET PRESENT VALUE 303886 INTERNAL RATE OF RETURN 18.54% (Using IRR function over the net cash flow) Based On IRR ,Update existing systemis recommended PaybackPeriod=Period at which Cumulative cashflow =NIL Payback Period=2+(239866/1015367) 2.2 Years Paybackperiod does not take into account Time value of money It does not differentiate between receipt of money earlier or later within paybackperiod Based on PaybackPeriod , Update existing systemis recommended
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