Question

Beryl’s Iced Tea currently rents a bottling machine for $50,000 per year, including all maintenance expenses. It is considering purchasing a machine instead, and is comparing two options:

a.   Purchase the machine it is currently renting for $150,000. This machine will require $20,000 per year in ongoing maintenance expenses.

b.   Purchase a new, more advanced machine for $250,000. This machine will require $15,000 per year in ongoing maintenance expenses and will lower bottling costs by $10,000 per year. Also, $35,000 will be spent upfront in training the new operators of the machine.

Suppose the appropriate discount rate is 8% per year and the machine is purchased today. Maintenance and bottling costs are paid at the end of each year, as is the rental of the machine. Assume also that the machines will be depreciated via the straight-line method over seven years and that they have a 10-year life with a negligible salvage value. The marginal corporate tax rate is 35%. Should Beryl’s Iced Tea continue to rent, purchase its current machine, or purchase the advanced machine?

Answer 1

The Net Present Value of renting option is -$218,078

The Net Present Value of option 1 (purchasing the current machine) is -$198,183

The Net Present Value of option 2 (purchasing the advanced machine) is -$241,728

The Net Present Value of option 1 --- purchasing the current machine is at the lowest among all alternatives. Hence, Beryl’s Iced Tea should purchase the current machine.

Workings: