A factory is considering investing $60 000 in a new machine. Management estimate

Question

A factory is considering investing $60 000 in a new machine. Management estimates that for the first two years, the cash inflows for the machine will equal the cash outflows. However, they expect net cash flows to be $20 000 in years 3 to 5 and $10 000 in years 6 to 9. If the cost of capital is J1=7.5%, should the factory buy the new machine ?

A factory is considering investing $60 000 in a new machine. Management estimates that for the first two years, the cash inflows for the machine will equal the cash outflows. However, they expect net cash flows to be $20 000 in years 3 to 5 and $10 000 in years 6 to 9. If the cost of capital is J1=7.5%, should the factory buy the new machine ?

Explanation / Answer

For the first two years, the cash inflow for the machine is equal to the cash outflow.

So, the net cashflow is zero.

For the next 3 to 5 years the net cashflow is $20,000. And again for 6 to 9 years the net cashflow is $10,000.

So, the net cashflow in 9 years is $20,000 + $10,000 = $30,000

The cost of capital is J1 = 7.5%

So, the return received after 9 years is 60,000 × 0.075 × 9 = $40,500

Since the net cashflow is less than the return received at cost of capital. So, the factory should not buy new machines

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