The operations department of a major FI is planning to reorganize several of its back-office functions. Its current operating expense is $1.5 million, of which $1 million is for staff expenses. The FI uses a 12 percent cost of capital to evaluate cost-saving projects.
a. One way of reorganizing is to outsource a portion of its data entry functions. This will require an initial investment of approximately $500,000 after taxes. The FI expects to save $150,000 in annual operating expenses after taxes for the next seven years. Should it undertake this project?
b. Another option is to automate the entire process by installing new state-of-the-art computers and software. The FI expects to realize more than $500,000 per year in after-tax savings, but the initial investment will be approximately $3 million. In addition, the life of this project is limited to seven years, at which time new computers and software will need to be installed. Using this seven-year planning horizon, should the FI invest in this project? What level of after-tax savings would be necessary to make this plan comparable in value creation to the plan in part (a)?