4. Critical analysis Q9 Suppose you are contemplating the purchase of a commerci

Question

4. Critical analysis Q9 Suppose you are contemplating the purchase of a commercial lawn mower at a cost of $13,000. The expected lifetime of the machine is three years. You can lease the asset to a local business for $5,000 annually (payable at the end of each year) for three years. The lessee is responsible for the upkeep and maintenance of the machine during the three-year period. Use the preceding information to calculate the present value of the income from the investment to decide if the investment will be profitable in each of the following two cases. Suppose you can borrow (and lend) money at an interest rate of 10%. At this interest rate, the $13,000 investment required to purchase the lawn mower be profitable. Now, suppose you can borrow (and lend) money at an interest rate of 16%. At this interest rate, the $13,000 investment required to purchase the lawn mower be profitable.

Explanation / Answer

Calculation of present value of the income from the investment (Interest rate @ 10%) Year Lease Income Discount Factor @ 10% Present Value 1 $5,000           0.90909 $4,545.45 2 $5,000           0.82645 $4,132.23 3 $5,000           0.75131 $3,756.57 Present Value of Income from Investment $12,434.26 At 10% interest rate , the $13000 investment required to purchase the lawn mower will not be profitable. Calculation of present value of the income from the investment (Interest rate @ 16%) Year Lease Income Discount Factor @ 16% Present Value 1 $5,000           0.86207 $4,310.34 2 $5,000           0.74316 $3,715.81 3 $5,000           0.64066 $3,203.29 Present Value of Income from Investment $11,229.45 At 16% interest rate , the $13000 investment required to purchase the lawn mower will not be profitable. Under both scenarios , the present value of income from investment is lower in comparison with purchase cost of lawn mower. Hence investment in lawn mower is not profitable under both cases.

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