Proust Manufacturing Co. produces personal fitness machines. The once successful

Question

Proust Manufacturing Co. produces personal fitness machines. The once successful line is no longer selling well, so the company is considering production of a new improved cardio-vascular machine. This can be done by buying needed production equipment. The after tax cash flow for buying this equipment is $700,000, at the beginning of Year 0. The alternative to produce the same output, is to lease that same equipment through four equal payments of $185,000 each year paid at the beginning of the year. The required rate of return (hurdle rate) for this business is 12 percent. Assume no taxes. Revenue from sales of the new cardiovascular machines is expected to be:

Year 1 - $375,000

Year 2

Explanation / Answer

Net present value of both the new purchase option and the lease option

New purchase option

NPV = -700000 + 375000/1.12 + 250000/1.12^2 + 140000/1.12^3 + 75000/1.12^4

NPV = - $ 18,567.01

Lease option

NPV = -185000 + (375000-185000)/1.12 + (250000-185000)/1.12^2 + (140000-185000)/1.12^3 + 75000/1.12^4

NPV = $ 52,094.20

Decision : Proust Manufacturing Co. should take equipment in lease

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