Question

Gravely Gears (GG) makes gears using an automated machine costs $12,000 and has a 25% probability of breaking irreparably at the end of each year (assuming it was working in the previous year). The machine has a maximum five-year life and will be disposed of with zero value at the end of five years. The machine produces $4,000 of cash flow at the end of each year and the discount rate is 8% per year. What is the expected number of years the machine will last and what would the value of the machine be? What is the NPV of the machine?

Answer 1

1. As the machine is expected to break @ 25% every year, the machine would be depreciated by $3,000/- ($12,000*25%) every year. Thus the machines expected life would be 4 years.

2. The value of the machine at the end of year 4 would be $0 as the machien owuld be fully depreciated by then even though the life of the machine is 5 years as it is being damaged at the rate of 25% every year.3.

3.Calculation of Net Present Value (NPV) :-

Initial Outflow - $12,000/-

Present Value of Inflows - $15,970.84/-

Inflows	PVF@8%	Present Value of Inflows
$        4,000	0.926	$           3,703.70
$        4,000	0.857	$           3,429.36
$        4,000	0.794	$           3,175.33
$        4,000	0.735	$           2,940.12
$        4,000	0.681	$           2,722.33
TOTAL	$        15,970.84

NPV = PV of Cash Inflows - Initial Cash Outflow

= $15.970.84 - $12,000/-

NPV = $3,970.84/-

As the NPV is Positive the purchase of machine should be accepted.