Siphamandla and Siphosethu is a business partnership set up by Siphamandla Mthembu and Siphosethu Mthembu some years ago. The partners are now considering the installation of a new computer system using specially written software to streamline the business's warehousing operations. The initial outlay on the project will be substantial. A feasibility study has already cost R20 000. Kaspar estimates that payments to the software house will be R100 000 immediately, with a further R75 000 in a year's time. New equipment and installation and testing costs will amount to R148 000 during the first year (it should be assumed for appraisal purposes that these costs arise at time 1). The plan is that the new system should go live in one year's time. After that point the business should start to reap considerable benefits from what will be, essentially, a paperless ordering and shipment tracking system. The partners plan to reduce their staffing levels considerably during the first two years during which the system is in operation and there will be other cost saving benefits including a reduction in office storage space, stationery, postage and other costs. Because of the increased efficiency of the operation, the partners also expect substantial increases in sales. The net cash inflows forecast from the installation of the new systems are as follows:
Time | R000
---|---
2 | 184
3 | 159
4 | 108
5 | 96
6 | 40
At the end of year six, the partners anticipate that the system will have to be scrapped and replaced with whatever is the latest technology at the time. There will be no residual value in the system at that point.
The partners have asked you to appraise the project to see how quickly it will pay back. You offer to appraise the project using discounted cash flow techniques, although Siphamandla (who did a business course a few years ago) is distinctly skeptical about this approach: 'The good thing about payback is that you can see immediately how long it's going to take to recoup the cost of the investment. Discounted cash flow doesn't make any sense to me'. However, he agrees that it might just be helpful to see what the NPV of the project is, and he estimates the business's cost of capital at 11%.
Required:
i) Calculate the payback period for the project (5 Marks).
ii) Calculate the NPV of the project using 11% as the discount rate (7 Marks).
iii) Briefly set out the arguments in support of the point of view that discounted cash flow techniques are superior to payback as a method of investment appraisal. (8 Marks).