Reference no: EM132962717

Capital Budgeting

• First Republic Bancorp is considering the acquisition of a new data processing and management information system. The system, including computer hardware and software, will cost $1 million. Delivery and installation of the system is expected to add $100,000 to this cost. To put this new system in place, the bank expects to have to make an investment of $50,000 in net working capital immediately and an additional net working capital investment of $25,000 at the end of year 1. The system has an expected economic life of 10 years. It will be depreciated as a 7-year asset under MACRS rules. Actual salvage value at the end of 10 years is expected to be $100,000, and the bank plans to sell the system for its salvage value at that time.
• The new data processing system will save the bank the $190,000 fee per year that it currently pays to a computer time-sharing company. Operating, maintenance, and insurance costs for the system are estimated to total $50,000 during the first year. These costs are expected to increase at a rate of 7 percent per year over the 10-year period.

First Republic plans to sell excess computer time to a number of local firms. The demand function for this service during year 1 is estimated to be:

Q=20,000-200P

where Q= number of units of computer time sold, and P= price per unit of computer time sold.

• Based on an analysis of the local market for computer time, the bank feels that it can charge $14 per unit of computer time. Although the bank does not anticipate changing this charge over the 10-year period, it expects the quantity demanded to decline by 5 percent per year after year 1. It is expected that these outside sales of computer time will cost the bank an additional $40,000 per year in computer operating costs (including the salary of a computer services representative to handle the new customers). These additional operating costs are expected to increase at a rate of 7 percent annually over the 10-year period.
• The bank has a marginal ordinary tax rate of 34 percent. This rate is expected to remain in effect over the life of the project. First Republic uses an after-tax cost of capital of 15 percent to evaluate projects of this risk. This cost of capital was computed based upon the current after-tax cost of equity and debt funds in the bank's capital structure.

Problem 1: Based on the information contained in the case, use the NPV approach to determine if First Republic should acquire the new data processing system.