Question

1. Suppose a small company considers expanding its business. Buying new machinery and related equipment will cost $200,000 (which the owner has available from past profits). Owner has calculated that that investment will raise revenues by $23,000 per year. The owner also estimates that it will become necessary to replace the new machinery after 8 years. Should the owner buy the additional machinery if the real interest rate is 3 percent? What if it were 3.5 percent? Since this is company’s cash flow, should the owner care about the interest rate at all?

Answer 1

ANSWER

NPV = - $ 200,000 + $ 23,0001.03¹ + $ 23,0001.03² + $ 23,0001.03³ + $ 23,0001.03⁴ + $ 23,0001.03⁵ + $ 23,0001.03⁶ + $ 23,0001.03⁷ + $ 23,0001.03⁸

NPV = - $ 38,547.08

At 3% interest rate, the company should not make the investment because the NPV is negative

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NPV = - $ 200,000 + $ 23,0001.035¹ + $ 23,0001.035² + $ 23,0001.035³ + $ 23,0001.035⁴ + $ 23,0001.035⁵ + $ 23,0001.035⁶ + $ 23,0001.035⁷ + $ 23,0001.035⁸

NPV = - $ 41,899.02

The company should not make the investment at 3.50% because the NPV is negative

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Since this is company’s cash flow, should the owner care about the interest rate at all?

yes, as it can make the investment profitable.

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