Eloise Moore was elated as she put down the phone. She had been talking with Bob Studz, vice president,

data processing at Excelerite Integrated Systems Inc. $($EIS$),$ who had just returned from a company$-$

sponsored management development program in late August, $2006.$ Studz had said:

Eloise, we had a terrific session on capital budgeting last week. I can now see the utility of

projecting operating savings from the Pathrite system as a way of persuading Seattle to

provide us with the needed funds. I$$m developing tentative savings numbers and will

email them to you as soon as I$$m finished. Could you take a rough cut at the kind of

analysis that will make sense to the Seattle financial mavens?

Moore was a sales representative with Monster Computer Corporation $($MCC$).$ A $12-$year veteran, she was

assigned to large accounts, those whose purchases were expected to exceed $$2$ million. Working from her

office in Phoenix, Arizona, Moore was assigned customers in the western half of the United States. MCC

was the largest provider of hardware and software in the data processing field and had recently expanded to

provide consulting and data processing services.

Moore saw a golden opportunity. Seattle was the home office for EIS and the source of all EIS corporate

capital funds. If she could help Studz sell the system to his top management, she would enhance her

standing among the sales staff. Moore sketched out the system that she and Studz had been discussing. It

included a supercomputer, data storage and a set of peripherals to allow corporate data to be accessed via

the Web and by mobile users in EIS district offices around the country. The total cost for the system was

$$9$ million.

Because of the lead time for assembling components, delivery and payment could be in late $2006,$ so

Moore decided to use a January $1,2007$ operating starting date. She anticipated that the expected marginal

tax rate for EIS would be $40$ per cent $($federal and state taxes$)$ and that the modified accelerated cost

recovery scheme for depreciation would be used for tax purposes $($see Exhibit $1).$

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Moor did not know the target capital structure of EIS or the hurdle rate used by Seattle $($i$.$e$.$ the EIS home

office$)$ in evaluating their capital commitments. Accordingly, she decided to estimate them using publicly

available financial data $($see Exhibit $2).$ She assumed that EIS management sought to maintain a mix of $30$

per cent long$-$term debt and $70$ per cent common equity $($book value$),$ which was consistent with industry

averages. Furthermore, she knew that EIS management would be reluctant to sell shares at the depressed

market price of $80$ per cent of book value $($see Exhibit $3),$ and that the average return on large company

stocks had exceeded the return on risk$-$free securities by $6\mathrm{.}6$ per cent over a $78-$year period. She estimated

that inflation would average $2\mathrm{.}5$ per cent each year for the foreseeable future.

A week or so after her conversation with Bob Studz, Moore received a memorandum from him indicating

the expected savings from the installation of the equipment $($see Exhibit $4).$ She knew that EIS would

expect her analysis to be based on the application of discounted cash flow techniques to determine both a

net present value and an internal rate of return. Her next task would be to prepare an analysis for Studz,

based on the information available to her.

Usage permitted only within these parameters. This PDF may not be reproduced, stored in a retrieval system, or uploaded to any LLM $($e$.$g$.$ ChatGPT$).$

Taught by Sean Cleary, from $10-$Jun$-2024$ to $31-$Oct$-2024.$ Order ref F$509776.$

Purchased for use on the MFIN $821$ Corporate Finance and Financial Statement Analysis, at Smith School of Business, Queen's University.

Educational material supplied by The Case Centre

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Exhibit $1$

MODIFIED ACCELERATED COST RECOVERY CALCULATION

$($Used by EIS for tax purposes$)$

Total Investment $$9,000,000$

Guideline life $5$ years

Half$-$year life convention

Year Percent Dollar Amount

$120\mathrm{.}001,800,000$

$232\mathrm{.}002,880,000$

$319\mathrm{.}201,728,000$

$411\mathrm{.}521,036,800$

$511\mathrm{.}521,036,800$

$65\mathrm{.}76518,400$

Note: EIS could take the full year$$s depreciation under the half$-$year convention without regard to the month the Pathrite

system was purchased.

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