Textbook Problem

Friedman Company is considering installing a new IT system. The cost of the new system is estimated to be $2,250,000, but it would produce after-tax savings of $450,000 per year in labor costs. The estimated life of the new system is 10 years, with no salvage value expected. Intrigued by the possibility of saving $450,000 per year and having a more reliable information system, the president of Friedman has asked for an analysis of the project’s economic viability. All capital projects are required to earn at least the firm’s cost of capital, which is 12 percent.

Required:

1. 1. Calculate the project’s internal rate of return. Should the company acquire the new IT system?
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 firm’s cost of capital. Comment on the safety margin that exists, if any.
3. 3. Suppose that the life of the IT system is overestimated by two years. Repeat Requirements 1 and 2 under this assumption. Comment on the usefulness of this information.