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

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.

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

Calculate IRR for each option

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

Buy Option :-

Outflow at the begining of the year = ($700,000)

Inflows are as below -

Year 1	600000
Year 2	500000
Year 3	300000
Year 4	200000
Year 5	100000

All this inflows are the end of the year.

Thus, NPV @ Cost of capital of 8% = Net cashflow at current time +( Net cashflow at end of year 1 /1.08) + ( Net cashflow at end of year 2 /1.08^2) + ( Net cashflow at end of year 3 /1.08^3) + ( Net cashflow at end of year 4 /1.08^4) + ( Net cashflow at end of year 5 /1.08^5)

= $ 737,439 (rounded Value)

Lease Option :-

Outflow at the begining of the year = ($50,000); rest all lease is paid at the end of each year.

Inflows are as below -

Year 1	600000
Year 2	500000
Year 3	300000
Year 4	200000
Year 5	100000

All this inflows are the end of the year.

Net Cash Flows at end of each year -

Year 1	480000
Year 2	380000
Year 3	180000
Year 4	80000
Year 5	-20000

Thus, NPV @ Cost of capital of 18% = Net cashflow at current time +( Net cashflow at end of year 1 /1.18) + ( Net cashflow at end of year 2 /1.18^2) + ( Net cashflow at end of year 3 /1.18^3) + ( Net cashflow at end of year 4 /1.18^4) + ( Net cashflow at end of year 5 /1.18^5)

= $ 771,764 (rounded Value)

Thus net present value of the Lease option is better than Buy Option. Thus, Jones Manufacturing should go for Lease Option.

For Buy option -

Net Cashflow at the end of the year	Year 1	-100000
	Year 2	500000
	Year 3	300000
	Year 4	200000
	Year 5	100000

IRR = 460%

For Lease option -

Net Cashflow at the end of the year	Year 1	-270000
	Year 2	380000
	Year 3	180000
	Year 4	80000
	Year 5	-20000

IRR - 84 %

Such high return are not possible realistically.