Simplace is a hotel and resort group with operations in Hong Kong, China and South East Asia. In a senior management meeting held in last month, the Group Financial Controller raised the issue of staff turnover rate in the Accounting Department. He pointed out that in the previous six months; more than 20 per cent of the department's employees had resigned. He believed that apart from the improved job market for qualified accountants, a more serious problem was the long working hours in the department. The root cause, largely, was the inability of the existing accounting system installed ten years ago to cope with many of the management reporting requirements in an environment where a series of new accounting standards had recently been introduced.?

After learning of the situation, the CEO approved a request to replace the accounting system. Two vendors, Coca and Cola, submitted proposals to Simplace. Coca is the market leader in accounting systems. It is well known for system reliability and its experienced implementation team. To install the system, Simplace would need to invest Rs3.8 million in the system hardware. A consultancy fee of Rs1.4 million and a license fee of Rs800,000 would be charged at the beginning of the project. In each subsequent year, Simplace would still have to pay an annual maintenance fee equivalent to 17 per cent of the license fee to Coca. Although the total investment would be sizeable, the Group Financial Controller estimated that the savings from enhanced efficiency in its operation would amount to Rs2 million each year. With a fast changing environment, he anticipated that the new system would become obsolete in five years' time and without any residual value.

Compared to Coca, Cola is a much younger company. However, in the last two years, it has successfully added several reputable companies to its client list. These companies were impressed by the innovative design and flexibility of the system. Simplace would have to invest Rs2.75 million in its hardware before it could install Cola's system. Cola's aggressive bid offers attractive pricing. It quotes an upfront consultancy fee and license fee of Rs1 million and Rs750,000 respectively. Twelve months after installation, Cola would charge an annual maintenance fee equivalent to 15 per cent of the license fee for each year afterwards. The Group Financial Controller estimated that Cola's system could assist the Accounting Department to generate an operational saving of Rs1.5 million at the end of the first year. The vendor also assured Simplace that it would invest heavily in R&D and hence it is confident that savings would increase by 10 per cent each year. To attain the full incremental savings, however, Cola stated that Simplace would have to put in an additional Rs1.25 million to upgrade its hardware in year 3. The life and residual value of Cola's system are expected to be the same as those of Coca. No matter which system is chosen, Simplace will not incur a maintenance fee for the last year in use. Use an annual discount rate of 11 per cent to carry out the following analysis.

Required

(a) (i) Calculate the net present value (NPV) of each system. (10 marks)

(ii) Assuming that the internal rate of return (IRR) of Coca's and Cola's systems are 17.2 per cent and 17.9 per cent respectively, which system is financially more attractive? State your reasons. (5 marks)

(b) Apart from the reasons in (a)(ii), what non-financial factors would you consider before making a recommendation to the Group Financial Controller on the choice of system? (10 marks)

(c) Describe two situations where the use of IRR will result in incorrect or problematic decisions. Why is IRR still a widely used tool? (10 marks)

(d) Research indicates that the IRR method is extremely popular even though it has shortcomings when compared to the NPV method. Why might managers prefer to use IRR rather than NPV when carrying out discounted cash flow evaluations? (5 marks)

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