Question

5. You ask your recent MBA hire to evaluate the attractiveness of an investment in a piece of computer equipment you've been interested in. He gives you the following report. (Assume that he at least collected all the figures correctly.) The equipment cost $150,000 and will be straight-line depreciated over 5 years. It will replace an existing system -- that would otherwise be used for the five years -- which has been fully depreciated and could be sold for $3,000. It requires the use of software, which the firm has recently purchased for $20,000. The equipment will improve efficiency, which will allow you to cut costs by $60,000/year. The maintenance of the product requires the time of 1/10th of an employee with salary $30,000 and who generates $50,000 of profits to the firm. An additional $5,000 must be reserved for operations. You know that you can sell this product after 5 years for $50,000. Your firm is taxed at 30%. Last year, your firm had a price increase of 15%. You also know that firms who are only in this no-growth business are trading at a P-E multiple of 10. You receive the following analysis with a recommendation against the investment:

                        0          1          2          3          4          5

                        ---        ---        ---        ---        ---        ---

Cost Savings               60        60        60        60        60

Maintenance               -3         -3         -3         -3         -3

Buy Eqpt      -150                                                       50

Sell Old            3

OppCost of

150K at 15%               -22       -22       -22       -22       -22

Depreciation               -20       -20       -20       -20       -20

Software      -20

                        --------------------------------------------------

EBIT          -167          15        15        15        15        65

Taxes                          4.5       4.5       4.5       4.5       19.5

                        --------------------------------------------------

Net CF        -167         11        11        11        11        46  

IRR<0<Required 15% return. Is this analysis correct? If not, where did your MBA go wrong? Redo the analysis to determine whether you should invest in the new equipment.

Answer 1