The CEO of Riverside Manufacturing, is reviewing the possible acquisition of automated manufacturing equipment. If the system is purchased, the company expects to realize annual cash savings as follows:

Reduced waste $300,000
Improved quality $400,000
Other reduced manufacturing costs $600,000
Improved on-time deliveries $200,000

The new equipment will cost $9,000,000 and is expected to have a 10-year useful life. The company uses a discount rate for capital budgeting of 12%.

Complete the following:
1. Determine the payback period. Company policy is to only accept projects that have a payback period of five years or less. Should the system be purchased?

2. Determine the net present value (NPV) and the internal rate of return (IRR) for the purchase of the equipment. Does this change your recommendation regarding the purchase of the equipment? Why or why not?

3. After further review by the manager of the project, it was determined that two more items should be included in the analysis:

a. The system would have a salvage value, net of any tax effect, at the end of the 10 years of $1 million.

b. Due to increased quality of production and more timely delivery, market share would likely increase by 20%. This would result in an additional increase in annual cash flow of $300,000.

Using this additional information, recalculate the payback period, the NPV, and the IRR. Does this change the decision? How much effect does salvage value have on the overall profitability of the project?

4. (Ignore the additional information in #3) Assume that operation of this equipment will require a working capital investment over the 10-year life of the project of $150,000. Recalculate the NPV and IRR including this working capital investment. What difference does this make?

5. (Ignore the additional information in #3 & #4) Assume that the company is subject to corporate income taxes of 15%. What is the effect on NPV and IRR?