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