Leo Thayn, manager of the Electronics Manufacturing Division, has been pushing headquarters to grant approval for the installation of a new computer-aided design system. Finally, in the last executive meeting, Leo was told that if he could show the new system would increase the firm’s value, then it would be approved. Leo has collected the following information: 922 Part 4 Decision Making 20-19 LO1, LO4 20-20 LO1, LO3, LO5, LO6 20-21 LO3, LO5, LO6 Old System CAD System Initial investment — $1,250,000 Annual operating costs $300,000 $95,000 Annual depreciation $100,000 MACRS Effective tax rate* 34% 34% Cost of capital 12% 12% Expected life 10 years 10 years Salvage value none none *The division is located in a state that provided a tax incentive package that lowers the tax rate from the usual average of 40 percent to 34 percent. This incentive package was granted for a 15-year period. Ten years of benefits remain. With the exception of the cost of capital, the preceding information ignores the rate of inflation, which has been 4 percent per year and is expected to continue at this level for the next decade. 

Required:

1. Compute the NPV for each system. 

2. Compute the NPV for each system, adjusting the future cash flows for the rate of inflation. 

3. Comment on the importance of adjusting cash flows for inflationary effects.