Case Scenario:
Spirit Software Inc. is a computer software company that generated $ 12 million in pre-tax operating income on $ 100 million in revenues last year; the firm is stable and does not expect revenues or operating income to change over the next 10 years. Its inventory management is in shambles and inventory as a percent of revenues amounted to 12% last year. Spirit is considering investing in a new inventory management system, which will cost $ 15 million. The inventory management system is expected to have a 10-year life, over which period it can be depreciated straight line down to a salvage value of zero. The new inventory management system is expected to have two benefits:
- It will immediately reduce the inventory maintained of items that are least sold and lower the inventory/sales ratio to 8% (and stay at that percentage level for the life of the inventory management system)
- By providing salespeople with updated information on what is in stock, it is expected to increase revenues to $ 115 million next year (and operating margins to remain unchanged). The revenues and operating income from year 2 to year 10 will remain unchanged at year 1 levels.
The reduction in inventory will also allow the company to sell off its existing storage facility (which has a book value of $ 5 million) today for $ 10 million and buy a new storage facility for $ 5 million. Both the old and the new storage facilities will be depreciated straight line over the next 10 years to a salvage value of zero.
The firm has an income tax rate of 40%, a capital gains tax rate of 20% and a cost of capital of 10%.
Q1. Estimate the future cash flows at time 0 (today) from this investment.
Q2. Based on the information would you invest in this company