Question

Your company is deciding whether to invest in a new machine. The new machine will increase cash flow by $180 per year and forever. The machine is currently priced at $2,000. The cost of the machine will decline by $25 per year until it reaches $1,800, where it will remain. If your required return is 8%, should you purchase the machine? If so, when should you purchase it? What is the value of option to wait?

Answer 1

Solution:

Statement showing net present value of machine at each year

Year	Cost of machine(a)	Incrementa cash flows	Present value Incrementa cash flows($180/0.08)(b)	Net Present value(b-a))	NPV at year 0(today)[NPV/1+0.08)^n]
0(Today)	$2000	$180	$2250	$250	$250.00
1	$1975	$180	$2250	$275	$254.63
2	$1950	$180	$2250	$300	$257.20
3	$1925	$180	$2250	$325	$258.00
4	$1900	$180	$2250	$350	$257.26
5	$1875	$180	$2250	$375	$255.22
6	$1850	$180	$2250	$400	$252.07
7	$1825	$180	$2250	$425
8	$1800	$180	$2250	$450

Since the NPV of machine is positive,hence nmachine should be purchased.

Since the today NPV is highest at year 3rd,hence machine should be purchased in year 3.

Value of option to wait is $8.00