Two new production scheduling information systems for Ferro Corporation could be

Question

Two new production scheduling information systems for Ferro Corporation could be developed at a cost of $105,000 and $135,000 respectively. Interest rate is 15%. The estimated net operating costs and estimated net benefits over five years of operation would be:

Project A

                        Estimated Net            Estimated Net           

Year                Operating Costs         Benefits

0                      $ 105,000                    0

1                      $     3,500                    $26,000

2                      $     4,700                    $34,000

3                      $     5,500                    $41,000

4                      $     6,300                    $55,000

5                      $     7,000                    $66,000

Project B

                        Estimated Net            Estimated Net           

Year                Operating Costs         Benefits

0                      $ 135,000                    $12,500

1                      $     3,800                    $21,500

2                      $     4,900                    $32,300

3                      $     5,800                    $35,300

4                      $     6,700                    $44,100

5                      $     7,800                    $61,000

Calculate payback period (PBP), net present value (NPV), and internal rate of return (IRR).

Which project do you recommend for development? Support your recommendation.

Please use the provided Excel template for this assignment.

Note: Interest Rate = (r + pt) = 15%

Explanation / Answer

(a) PBP is that time period by when a project's future cash inflows recover the initial investment, i.e. time by when project's cumulative cash flows become zero.

For project A, PBP lies between years 3 & 4.

PBP = 3 + (Absolute value of cumulative cash flow in year 3 / Cash flow in year 4)

= 3 + (17,700 / 48,700) = 3 + 0.36 = 3.36 years

For project B, PBP lies between years 4 & 5.

PBP = 4 + (Absolute value of cumulative cash flow in year 4 / Cash flow in year 5)

= 4 + (10,500 / 53,200) = 4 + 0.2 = 4.2 years

(b) NPV is the sum of all cash flows discounted at interest rate of 15%.

(c) IRR is that discount rate which makes NPV equal to zero. It is found out using Excel function =IRR().

As seen in part (b),

IRR, project A = 20.67%

IRR, project B = 9.17%

(d) Recommendation:

Since project A has a higher (positive) NPV and higher IRR, A should be chosen.

Project A Year Cost ($) Benefit ($) Net Cash Flow (NCF) ($) Cumulative NCF ($) (A) (B) (C) = (B) - (A) 0 1,05,000 -1,05,000 -1,05,000 1 3,500 26,000 22,500 -82,500 2 4,700 34,000 29,300 -53,200 3 5,500 41,000 35,500 -17,700 4 6,300 55,000 48,700 31,000 5 7,000 66,000 59,000 90,000 Project B Year Cost ($) Benefit ($) Net Cash Flow (NCF) ($) Cumulative NCF ($) (A) (B) (C) = (B) - (A) 0 1,35,000 12,500 -1,22,500 -1,22,500 1 3,800 21,500 17,700 -1,04,800 2 4,900 32,300 27,400 -77,400 3 5,800 35,300 29,500 -47,900 4 6,700 44,100 37,400 -10,500 5 7,800 61,000 53,200 42,700

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