Question

Jones Manufacturing Co. produces personal fitness machines. After five years, the once successful line is no longer selling well, so the company is considering production of an improved line of machines incorporating new computer technology. This can be done by buying needed production equipment. There is a six-month manufacturing, delivery, setup, and training delay before the equipment will be ready for production. The company wants to start producing the new line of fitness machines in January next year. Two options are available - lease or buy.

Buy Option - The entire purchase price of the production equipment is $700K and is due at the time of the order. The cost of capital for this purchase is 8%. Assume: (1) the equipment has no residual value at the end of the fifth year and (2) there are no taxes.

Lease Option - The total lease cost is $600K. A $50K deposit is due at the time of the order. The remaining portion of the first year's lease payment ($70K) is due in January next year. The other four annual lease payments ($120K each) are due in January of production years 2, 3, 4, and 5. The cost of capital for leasing is 18%. Assume no taxes.

Revenue from sales of the new line of fitness machines is expected to be:

* Year 1 - $600,000

* Year 2 - $500,000

* Year 3 - $300,000

* Year 4 - $200,000

* Year 5 - $100,000

1. Calculate the net present value of both the new purchase option and the lease option. Show all work. Determine the best option for Jones and justify your answer.

2. You used the Excel NPV function with the correct discount rates to calculate NPV and you got the following values: Buy - $682,814; Lease - $689,947. What did you do wrong?

3. Calculate IRR for each option.

4. Assuming projected inflows and outflows are accurate, under what conditions can Jones expect to see a return equal to IRR? Is this realistic?

Answer 1