You ask your recent MBA hire to evaluate the attractiveness

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

 

 

 

 

 

Oppurtunity cost 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.

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