Question

Capital Budgeting Case
Scanning: Evaluating a new technology
National Courier Company picks up and delivers packages across the country and, through its relationships with couriers in other countries, provides international package delivery services. Each afternoon couriers pick up packages. In late afternoon, the packages are returned to the courier's terminal, where they are placed in bins and shipped by air to National Courier Company's hub. In the hub, these bins are emptied. The packages are sorted and put into different bins according to their destination terminal. Early the next morning, the bins arrive at the various destination terminals, where they are sorted by route, put onto trucks, and delivered.
An operations study determined that about $2 million of employee time could be saved each year by using a scanning system. Each package's bill of lading would have a bar code that the courier would scan with a handheld scanner when the package is picked up. The shipment would be scanned again as it reaches the terminal, when it leaves the terminal, when it reaches the hub, when it is placed into a bin at the hub, when it arrives at the destination terminal, when it is sorted onto a courier's truck for delivery, and when it is delivered to the customer. Each scanning would eliminate the manual and less accurate completion of a form, thereby providing courier time savings.
The total cost of the scanning system is estimated to be $10 million. It is thought to have a life of six years, after which the equipment will be replaced with new technology. The salvage value of the equipment in six years is estimated to be $500,000.
At the end of each shift, the information from all the scanners will be
loaded into National Courier Company's main computer, providing the exact location of each shipment. This tracking information provides for increased security, a lower mis-sort rate, and improved service in tracing shipments that have been mis-sorted. The reduced time spent tracing missing shipments ac-counts for the balance of the estimated employee time savings. The marketing manager believes that the increased security and service will result in an increased contribution margin of about $1 million per year if competitors do not adopt this technology and National Courier Company does. If competitors buy this technology and National Courier Company does not, it will lose $1 million in contribution margin. If everyone buys this technology, each competitor will maintain its current sales level.
If National Courier Company's marginal tax rate is 35% and it has an after-tax cost of capital of 6%, should it make this investment?
Assume that National Courier Company will use straight-line depreciation to compute de-preciation for tax purposes.

Answer 1

Facts of case

The cost of system = $ 10 millions

Useful life = 6 years

Salvage value = $ 500000

Depreciation per year = $ 10 - 0.5 millions / 6 Year = $ 1583333

We will find out the Net present value of this proposal to take the required decision

NPV = Present Value of all the benefits - Present Value of costs

(exclude depreciation because non cash expense is not relevant for decision making although DTS is relevant because it’s saving in cash expense ie tax)

Total benefits

1) Depreciation tax shield = 1583333*35% = $ 554167 per year

Present value of DTS = 554167* PVAF(6%,6) = $ 2725019

2) Cost saving + Additional contribution margin = $ 2+1 millions = $ 3000000 per year

Present value of these benefits = $ 3000000* PVAF(6%,6) = $ 14751973

3) Present value of salvage value = $ 500000* PVIF(6%,6)= $ 352480

So Total present value of benefits

$ 2725019+ 14751973 + 352480 = $ 17829472

Less: Cost of scanning system = $ 10000000

Net present value of investment = $ 7829472

Because The NPV is positive the business should make this investment.