As a financial advisor at RedHat International (RHI), you have been asked to evaluate two
capital investment alternatives submitted by the shipping department. Before beginning your
analysis, you note that company policy has set the minimum desired rate of return at 20% for all
proposed projects. You also learn that the corporate tax rate is 24%.
The proposed capital project calls for the shipping department to fully automate a warehouse
using one of two different advanced robotics systems. System A will incur development costs of
$2,500,000. System B will cost $4,000,000 to develop. Both systems will be capitalized and
amortized using a CCA rate of 20%. In addition, the firm believes that Net Working Capital will
rise by $50,000 at time zero and then by an additional $10,000 at the end of each year for each
year that the new system is operating (except at the end of the final year of the project). This
applies to both alternatives. However, all of the increase in Net Working Capital will be
recovered at the end of the project.
The Shipping Department intends to hire an outside consultant at a cost of $10,000 to help it
choose which of the two alternatives would be most effective. If neither alternative is financially
attractive, the consultant will be expected to point this out to the company. The amount paid to
the consultant will be expensed at the time it is incurred.
To recover a portion of the development cost, the shipping department intends to charge the
manufacturing department for the use of computer time at the rate of $150 per hour for 50 hours
per year for each year of the project. This amount will remain the same under either alternative.
RHI owns all of its computer equipment, which has significant spare capacity. The company
plans to maintain this spare capacity into the future. However, it is company policy not to rent
spare computer capacity to outside users due to security concerns.
If the new automated robotics system is put into use, the pre-tax cost savings each year are
estimated as follows:
Year System A System B
1 $1,500,000 $2,000,000
2 $1,200,000 $1,750,000
3 $1,000,000 $1,500,000
4 $ 950,000 $1,250,000
5 $ 900,000 $1,100,000
Figure 1
As the capital budgeting analyst, you are required to draft a comprehensive memo, addressed
to: The Manager, Shipping Department, answering the following questions:
1. How should you handle the $10,000 payment to the Consultant? Why? Be specific.
2. How should you handle the $150 per hour charge for computer time charged by the
shipping department to the production department? Why? Be specific.
3. What discount rate should you use? Why?
4. Calculate the NPV of each alternative using the five steps of capital budgeting and the
cost savings shown in Figure 1 above. For Question #4, assume that there is no
ACCT 3380 – Summer 2022 2 Introductory Managerial Finance
salvage value. At this stage of the analysis, we are assuming that at the end of the
equipment’s five-year life, it will be scrapped for zero value.
5. In Question #5, the CFO is concerned that a change in technology might make the new
system obsolete after three years. If this occurs and you only obtain three years of cost
savings (as per Figure 1 above) and no salvage value, which alternative (if any), would
you now recommend?
6. In Question #6, the vendors of both systems have indicated that they are working on a
new generation of robotics which they expect will totally eliminate the function of the
current generation of equipment. If they are able to do this, they would be willing to
repurchase the current systems for the following amounts:
System A System B
End of Year 3 $500,000 $500,000
End of Year 4 $300,000 $300,000
End of Year 5 0 0
Cost savings for the years the systems are in use will remain as shown in Figure 1
above and the impact on Net Working Capital will remain as stated up to the point that
the equipment is withdrawn from service (with all working capital recovered at the end of
the last year of service). If the vendors do manage to develop the new generation of
equipment, should the shipping department purchase the current generation and then
sell back to the manufacturer when the new systems are released? If so, what would be
the optimal year to salvage the equipment? Be specific.
Each submission must be an electronic copy, emailed to the Instructor, that includes:
1. A title page, showing the full names and student IDs of all group members
2. A declaration, certified by each student, that reads as follows:
“I hereby declare that all of the work in this Assignment is my own. It has not
been copied from any other student’s work, regardless of when that person was a
student at Kwantlen. Should this be shown not to be true, I understand that I and
each of my group members will receive a mark of 0% (ZERO) for this component
of the course”.
3. A short, well written, Executive Summary
4. A body of the report that shows the complete solution to each of the problems, including
a Summary Table at the end of each of Questions 4, 5 & 6 in the form shown in the
PowerPoint for Week 8 (see summary slide at the end of the Cost Cutting Example #1,
should be around slide 27)
5. All formulas must be typed
