Allentown Environmental Services

The success of Allentown Environmental Services depends on Mike and Tims capital investment decision. They must decide either to: (1) install a new information technology system or (2) update the existing information technology system. Each alternative offers Allentown Environmental Services advantages and disadvantages in remaining a market leader in water engineering management. Only time will tell if Mike and Tim made the right decision. Such is the case for many difficult business decisions. You need to work with Mike and Tim and help them make the best decision possible at this time with the available data.

The following conversation between Mike and Tim illustrate the challenges they face:

Mike: Tim, Im not sure what we should do about our information technology capital investment decision. Should we simply purchase a new information technology system or update the existing system? Our software vendor no longer supports the products we use, and our hardware is very old. The competition provides higher quality consulting services than we do by leveraging information our current information technology system doesnt provide. To remain in business and operate competitively, we must change. Yet, what is the best decision for today and for the many years to come? What are the risks in purchasing a new information technology system compared to the risks in updating the existing system?

There are a number of different tools for analyzing a capital investment decisions, but some of the simplifying assumptions built into the models trouble me. For example, how is it possible to forecast a specific increase in profitability three to six years from today, when the estimate is based on subjective data, such as, better customer information? My gut feeling is that assumptions built into the tools have a significant effect on our information technology decision.

Tim: Mike, I agree with your concerns, especially when we consider the intangibles. Can the sales team actually grow revenues and increase cash flows with the additional customer information provided by the new or updated existing information technology system?

Mike and Tim face a difficult business challenge. They must select an information technology system that offers the greatest short- and long-term benefits for Allentown Environmental Services and its workforce, and balance the benefits against the risk of changing the information technology system. The managing partners request that you evaluate two mutually exclusive investment alternatives: either to (1) purchase a new information technology system or (2) update the existing information technology system, and then make a recommendation to the managing partners. When making your recommendation, you must make explicit the many assumptions and that often comprise a capital investment decision.

Allentown Environmental Services believes they must improve their current information technology system to obtain the following potential benefits:

• An efficient and effective inventory supply and contractor management system
• The ability to capture more information on customers needs
• The ability to capture and share information about engineering jobs among the engineering groups
• A radio frequency identification (RFID) tracking system
• A support staff that is more efficient and effective (Allentown Environmental Services offers retraining for a new position in the company to any support staff function eliminated as a result of information technology changes)
• Resource consumption information must remain cost competitive

Allentown Environmental Services began operations in 1975. The company provides water management engineering services for developers, city planners, and architectural firms nationwide. Competitors view Allentown Environmental Services as the market leader in the water management systems industry. Consequently, Mike and Tim must invest in a new or updated information technology system to meet customer needs and remain a market leader.

Allentown Environmental Services engagements span a wide range of services. A routing engagement, for example, entails the design and engineering of residential housing development water management systems. Specific services include detailed landscape plans for rainwater drainage, and the design for fresh water flow into the development as well as the flow of wastewater back into the drainage system.

An example of a complex engagement is the design and engineering of airport water management systems. Services include the design of runway water management systems, complex and integrated water management systems for airport terminals, aircraft waste disposal systems, fire safety systems, restaurant support systems, and other facilities that serve a large population. Allentown Environmental Services partners critically supervise the construction process of all jobs. Moreover, customers appreciate the attention Allentown Environmental Services gives to every detail. Projects currently at various stages of completion include residential developments, a hospital, and an airport.

Exhibit 1 contains information related to estimated costs and savings associated with the purchase of a new information technology system.

Exhibit 2 contains information related to estimated costs and savings associated with the update of the existing information technology system.

Required:

1. Compute the payback period for the two alternatives. Discuss the advantages and disadvantages of using the payback period to evaluate capital investment decisions. Based on the results of the calculated payback period, which investment would you recommend that Mike and Tim pursue?
2. Assuming the company requires an 8% return from capital investments determine the net present value of the two alternatives. Discuss the advantages and disadvantages of using the net present value method to evaluate capital investment decisions. Based on the results of the calculated net present value, which investment would you recommend that Mike and Tim pursue?
3. Perform net present value calculations using the original cash flows but modifying the companys required return from capital investment decisions. First, assume the required rate of return is 6%. Next, assume the required rate of return is 10%. How would these modifications affect the recommendation that you would make to Mike and Tim?
4. Assuming the company has a hurdle rate for capital investments of 8% determine the internal rate of return for the two alternatives. Discuss the advantages and disadvantages of using the internal rate of return method to evaluate capital investment decisions. Based on the results of the calculated internal rate of return, which investment would you recommend that Mike and Tim pursue?
5. During a discussion with Mike, he indicated that he believes the cash flow estimates for the new system are very conservative. He feels that the net cash flows will be 10% larger than the numbers provided in years 2 through 6. How will those changes affect the payback period, NPV, and IRR?
6. Discuss any significant assumptions that are required when using each of the capital investment tools. Are there any concerns that you would want to bring to Mike and Tims attention related to these assumptions?
7. What is your final recommendation to Mike and Tim?

EXHIBIT 1

EXHIBIT 2

Exhibit 1 Purchase new system Initial Outlay Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Initial cash outflows S1,750,000 1,050,000 Hardware Software 200,000 250,000 1,500,000 750,000 $5,500,000 Training Site preparation Initial systems design Conversion Total initial cash outflow Recurring cash outflows Hardware expansion S $260,000 $300,000 $340,000 $380,000 $420,000 275,000 160,000 Software C 150,000 120,000 450,000 160,000 420,000 1,560,000 200,000 130,000 450,000 180,000 225,000 140,000 400,000 200,000 250,000 150,000 Systems maintenance RFID tags and scanner 60,000 500,000 200,000 220,000 100,000 240,000 Communication charges 100,000 Networking charges 300,000 960,000 490,000 560,000 630,000 700,000 Total cash outflows 1,750,000 1,865,000 1,830,000 1,895,000 Cash inflow 1,000,000 800,000 1,500,000 2,000,000 Clerical and general overhead cost 60,000 800,000 300,000 700,000 600,000 800,000 800,000 Working capital Profits from growing existing services 1,000,000 1,200,000 100,000 500,000 900,000 1,400,000 1,600,000 4,600,000 2,770,000 (941,800) 1,828,200 297,500 2,125,700 C 900,000 Profits from growing sales C 700,000 800,000 2,900,000 1,200,000 4,000,000 Total cash inflows 2,700,000 160,000 5,300,000 (800,000) Cash inflows less cash outflows 1,140,000 1,150,000 (391,000) 759,000 2,135,000 (725,900) 1,409,100 297,500 3,405,000 (1,157,700) 2,247,300 297,500 Less income taxes 272,000 (528,000) (387,600) 752,400 297,500 Cash inflows (outflows) net of tax Depreciation tax shield Net cash inflows (outflows) 297,500 297.500 (230,500) 1,049,900 1,056,500 1,706,600 2,544,800 Exhibit 2 Update existing system Initial Outlay Year 1 Year 2 Year 3 Initial cash outflows S 200,000 Hardware Software 250,000 200,000 100,000 Training Site preparation Initial systems design 800,000 Conversion 200,000 $1,750,000 Total initial cash outflow Recurring cash outflows Hardware expansion S 200,000 S S 0 0 100,000 100,000 Software 0 100,000 125,000 150,000 Systems maintenance RFID tags and scanner 60,000 500,000 300,000 Communication charges 100,000 160,000 180,000 Networking charges 100,000 200,000 860,000 250,000 1,005,000 760,000 Total cash outflows Cash inflows Clerical and general overhead cost 500,000 400,000 300,000 500,000 400,000 1,600,000 740,000 (251,600) 488,400 226,667 S 715,067 S 1,015,367 300,000 200,000 900,000 800,000 2,200,000 1,195,000 (406,300) 788,700 226,667 Working capital Profits from growing existing services Profits from growing sales 300,000 600,000 600,000 Total cash inflows 2,000,000 1,240,000 Cash inflows less cash outflows Less income taxes (421,600) 818,400 226,667 $1,045,067 Cash inflows (outflows) net of tax Depreciation tax shield Net cash inflows (outflows)