Question

Thompson Industries produces packaging materials. Thompson is considering undertaking one or both of two investment projects. The first investment involves a new automated warehouse for the firm’s foam and plastic inventory. The warehouse can be expected to have a useful life of ten years, after which it will be obsolete with no scrap value. The warehouse involves $3,000,000 in capital cost that must be paid immediately. The warehouse will lower the firm’s cost $400,000 for each of the first five years, and $500,000 per year thereafter. The second project involves the acquisition of a computerized order system that would allow the firm’s salespeople to link directly with the computer to place orders. The computerized network will require an initial capital cost of $1,000,000, but will save the firm $300,000 per year in support staff costs. Thompson’s managers believe that the order system will be obsolete after five years. Cash flows for each project will be at year end. Thompson uses a 10% discount rate in evaluating the investment projects. Interest rates and future cash flows are in real terms, net of all tax effects.
a) Calculate the net present value of each investment project. Which project(s) should the firm accept?
b) Comment on the impact of a change in the discount rate on the net present value (Analyze both an increase and a decrease in the NPV.)

Answer 1