Question

Aerotron Electronics is considering purchasing a water filtration system to assist in circuit board manufacturing. The system costs $45,000. It has an expected life of 7 years at which time its salvage value will be $7,000. Operating and maintenance expenses are estimated to be $2,000 per year. If the filtration system is not purchased, Aerotron Electronics will have to pay Bay City $11,500 per year for water purification. If the system is purchased, no water purification from Bay City will be needed. Aerotron Electronics must borrow 1/2 of the purchase price, but they cannot start repaying the loan for 2 years. The bank has agreed to 3 equal annual payments, with the 1st payment due at the end of year 2. The loan interest rate is 7.0 % compounded annually. Aerotron Electronics’ MARR is 10.5 % compounded annually.

a. What is the present worth of this investment?

b. What is the decision rule for judging the attractiveness of investments based on present worth?

c. Should Aertron Electronics buy the water filtration system?

Answer 1

a.

Loan amount = 45000 / 2 = 22500

Annual loan repayment = 22500*(F/P,7%,1)*(A/P,7%,3)

= 22500*1.07*0.381052

= 9173.83

NPW of investment = -22500 + (11500 - 2000)*(P/A,10.5%,7) - 9173.83*(P/A,10.5%,3)*(P/F,10.5%,1) + 7000*(P/F,10.5%,7)

= -22500 + (11500 - 2000)*(((1 + 0.105)^7-1)/(0.105*(1 + 0.105)^7)) - 9173.83*(((1 + 0.105)^3-1)/(0.105*(1 + 0.105)^3))*((1 + 0.105)^-1) + 7000*((1 + 0.105)^-7)

= -22500 + (11500 - 2000)*(((1.105)^7-1)/(0.105*(1.105)^7)) - 9173.83*(((1.105)^3-1)/(0.105*(1.105)^3))*((1.105)^-1) + 7000*((1.105)^-7)

= -22500 + (11500 - 2000)*4.789303 - 9173.83*2.465123*0.904977 + 7000*0.497123

= 6012.53

b.

if NPW > 0, select the project otherwise reject the project

c.

As NPW > 0, select the project