Question

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

ANSWER:AS NET PRESENT VALUE IS IN NEGATIVE PROJECT IS NOT VIABLE.

OPPORTUINITY COST IS NOT CONSIDERED IN NPV CALCULATION.

MAINTENANCE COST IS 1/10 OF 30000+50000=8000