The controller of Tim’s Travel (TT) is deciding between upgrading the company’s existing computer system or replacing it with a new one. Upgrading the four-year-old system will cost $97,500 and extend its useful life for another seven years. The book value is $19,500, although it would sell for $24,000. Upgrading will eliminate one employee at a salary of $19,400; the new computer will eliminate two employees. Additional annual operating costs are estimated at $15,950 per year. Upgrading is expected to increase profits 3.5%above last year’s level of $553,000.
The BetaTech Company has quoted a price of $224,800 for a new computer with a useful life of seven years. Annual operating costs are estimated to be $14,260. The average processing speed of the new computer is 12% faster than that of other systems in its price range, which would increase TT’s profits by 4.5%.
Tim’s present tax rate is 35%, and the cost of financing (minimum desired rate of return) is 11%. After seven years, the salvage value, net of tax, would be $12,000 for the new computer and $7,500 for the present system. For tax purposes, computers are depreciated over five full years (six calendar years; a half year the first and last years), and the depreciation percentages are as follows:
Using a spreadsheet package, prepare an economic feasibility analysis to determine if Tim’s Travel should rehabilitate the old system or purchase the new computer. As part of the analysis, compute the after-tax cash flows for years 1 through 7 and the payback, NPV, and IRR of each alternative.