Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Transcribed Image Text:Integrative Case Problem
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.
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