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 acquiring specialized 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 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

Let us first calculate NPV under both the options:-

1) Purchase the machine

Since there are no taxes, no dep tax savings is available.

So, NPV = Present value of inflows - Present value of outflows

= (600000/1.08) + (500000/1.08^2) + (300000/1.08^3) + (200000/1.08^4) + (100000/1.08^5) - 700000

= 555555 + 428669 + 238150 + 147006 + 68058 - 700000

= $737,438

2) Lease the machine

NPV = Present value of inflows - Present value of outflows

= (600000/1.18) + (500000/1.18^2) + (300000/1.18^3) + (200000/1.18^4) + (100000/1.18^5) - 50000 - (70000/1.18) - (120000/1.18^2) - (120000/1.18^3) - (120000/1.18^4) - (120000/1.18^5)

= 508474 + 359092 + 182589 + 103158 + 43711 - 50000 - 59322 - 86182 - 73036 - 61895 - 52453

= $814,136

Now, IRR is a rate at which NPV is zero.

So, IRR is a rate where return on investment can be equal if the NPV is zero. The same is realistic.