Question 2

Iceland Company is considering installing a new IT system. The cost of the new system is estimated to be R750 000, but it would produce after-tax savings of R150 000 per annum in labour costs. The estimated life of the new system is 10 years, with no salvage value expected. Intrigued by the possibility of saving R150 000 per annum and having a more reliable information system, the president of Iceland has asked for an analysis of the projects economic viability. All capital projects are required to earn at least the firms cost of capital, which is 12%.

Required:

2.1 Calculate the projects internal rate of return. Should the company acquire the new IT system? Why?

2.2 Suppose that savings are less than claimed. Calculate the minimum annual cash savings that must be realized for the project to earn a rate equal to the firms cost of capital. Comment on the safety margin that exists, if any.

2.3 Suppose the life of the IT system is overestimated by two years. Repeat the calculations in 2.1 and 2.2 under this assumption. Comment on the usefulness of this information.

Question 2

Iceland Company is considering installing a new IT system. The cost of the new system is estimated to be R750 000, but it would produce after-tax savings of R150 000 per annum in labour costs. The estimated life of the new system is 10 years, with no salvage value expected. Intrigued by the possibility of saving R150 000 per annum and having a more reliable information system, the president of Iceland has asked for an analysis of the projects economic viability. All capital projects are required to earn at least the firms cost of capital, which is 12%.

Required:

2.1 Calculate the projects internal rate of return. Should the company acquire the new IT system? Why?

2.2 Suppose that savings are less than claimed. Calculate the minimum annual cash savings that must be realized for the project to earn a rate equal to the firms cost of capital. Comment on the safety margin that exists, if any.

2.3 Suppose the life of the IT system is overestimated by two years. Repeat the calculations in 2.1 and 2.2 under this assumption. Comment on the usefulness of this information.