Parsifal Ltd is a private company whose ordinary shares are all held by its directors. The chairman has recently been impressed by the arguments advanced by a computer salesman, who has told him that Parsifal will be able to install a fully operational computer system for £161 500. This new system will provide all the data currently being prepared by a local data-processing service. This local service has a current annual cost of £46 000. According to the salesman, annual maintenance costs will be only £2000 and if properly maintained the equipment can be expected to last 'indefinitely'.
The chairman has asked the company accountant to evaluate whether purchase of the computer system is worthwhile. The accountant has spoken to a friend who works for a firm of management consultants. She has told him that Parsifal would probably have to employ two additional members of staff at a total cost of about £15 000 per annum and that there would be increased stationery and other related costs of approximately £4000 per annum if Parsifal purchased the computer system. She also estimates that the useful life of the system would be between 6 and 10 years, depending upon the rate of technological change and changes in the pattern of the business of Parsifal. The system would have no scrap or resale value at the end of its useful life.
The company accountant has prepared a net present value calculation by assuming that all the annual costs and savings were expressed in real terms and that the company had a real cost of capital of 5 per cent per annum. He chose this course of action because he did not know either the expected rate of inflation of the cash flows or the cost of capital of Parsifal Ltd. All cash flows, except the initial cost of the system, will arise at the end of the year to which they relate. You are required to:
(a) Estimate, using the company accountant's assumptions, the life of the system which produces a zero net present value,
(b) Estimate the internal real rate of return arising from purchase of the computer system, assuming that the system will last:
(i) For six years, and
(ii) Indefinitely,
(c) Estimate the value of the annual running costs (maintenance, extra staff, stationery and other related costs) that will produce a net present value of zero, assuming that the system will last for ten years,
(d) Discuss how the company accountant should incorporate the information from parts (a), (b) and (c) above in his recommendation to the directors of Parsifal Ltd as to whether the proposed computer system should be purchased,
(e) Discuss how the company accountant could improve the quality of his advice.