Capital Budgeting: Discounted Cash Flow Analysis

Tri-State Sewer and Water (1)

Capital Budgeting: Discounted Cash Flow Analysis

Tri-State Sewer and Water (TSSW) is considering replacing its computer systems (there are four of them currently) with a state-of-the-art SAP ERP (Enterprise Resource Planning) system.  The computer systems now in use are only a two years old and were purchased at a total cost of $240,000.  The estimated useful life of the computers at the time of their purchase was eight years with an estimated residual value of zero.

TSSW can continue to use the current systems for the next six years.  The depreciation expense of $30,000 would be tax deductible and the income tax rate is 40% (TSSW is a for-profit utility company).  Alternatively, TSSW can purchase the new SAP system for $870,000 and invest another $100,000 in up-front training.  Continuing training expenses at the rate of 10% (of the up-front training cost) are deemed necessary. The new system would be depreciated at the rate of $145,000 per year.  The old computers could be sold for $45,000.

Adoption of the SAP system would result in significant labor savings in the IT department.  In fact, only three of the seven people currently employed would be required.  The other four would replace normal attrition within the utility.  The average salary of the IT staff is $40,000 per year plus 30% fringe benefits.  TSSW also anticipates that SAP will generate annual productivity enhancements (cost reductions) in the amount of $65,000 per year arising from combining services that are currently duplicated across different departments (e.g., human resources, safety, training, accounting, finance, purchasing, warehousing, customer service, and maintenance).  

The cost of capital for TSSW for projects with this kind of risk is 12%.    

Should TSSW acquire the SAP system?  Prepare a timeline of cash flows and compute the NPV and IRR of the project.

Tri-State Sewer and Water (2)

Sensitivity Analysis

Biju George, one of the senior managers at TSSW, is skeptical of the magnitude and timing of the projected benefits of the SAP system.  Tony Parrott, on the other hand, believes the estimates are conservative.  Determine the effects on NPV and IRR of the following sensitivity analysis.