Question

A relative of the manager suggests her an offer of a well-known brand:

Pricing at $300,000, it would generate an income of ($90,000) annually. The offer includes the first-year maintenance service free of charge. So, the first annual maintenance service charge of $30,000 would be payable at the beginning of the second year. Its life span can last for 6 years. The salvage value would be ($3,000).

Draw a cash flow diagram for the offer and If the MARR is 10%, should this offer be chosen? Why? Also to save some money, you suggest the manager to seek for third party maintenance service instead of the original manufacturer at the beginning of the second year, which charges $20,000 annually. How would this suggestion influence the manager’s decision?

Answer 1

Initial price = $300,000

Annual income = $90,000

Life Span = 6 years

Salvage Value = $3,000

Salvage Value will be added to the incoming cash flow at end of Year 6 since that will be the resale value.

Annual Maintenance Service Charge from beginning of 2nd year = $30,000

MARR = 10%

Cash Flow Diagram

Here Yn = Nth Year

Since we need to decide whether this offer should be chosen or not we will calculate IRR. If IRR is more than 10% then we will select the offer.

Cash Flows

Year 0 = -300,000

Year 1 = 90,000

Year 2 = (90,000-30,000) = 60,000

Year 3 = (90,000-30,000) = 60,000

Year 4 = (90,000-30,000) = 60,000

Year 5 = (90,000-30,000) = 60,000

Year 6 = (90,000 + 3000 - 30,000) = 63,000

​Present Value= Future Value​​ / (1+r)t

​Initial Investment = 300,000

​Present Value Year 1 = 90,000/1.1 = 81818.1818182

​Present Value Year 2 = 60,000/1.12 = 49586.7769

​Present Value Year 3 = 60,000/1.13 = 45078.8881

​Present Value Year 4 = 60,000/1.14 = 40980.8073

​Present Value Year 5 = 60,000/1.15 = 37255.2794

​Present Value Year 6 = 63,000/1.16 = 35561.8575934

IRR = Sum of present value from Year 1 to year 6 - Initial Investment

       = 0.08818

   IRR = 8.818%

Since IRR is 8.818 % and MARR is 10% this offer should not be chosen as the return expected is lower than the Minimum Accepted Rate of return

According to new suggestion

The annual maintenance cost would be paid at the beginning of each year starting from year 1 and its cost would be 20,000 instead of 30,000

So new cash flows would be

Year 0 = -300,000 = Initial Investment

Year 1 = (90,000-20,000) = 70,000

Year 2 = (90,000-20,000) = 70,000

Year 3 = (90,000-20,000) = 70,000

Year 4 = (90,000-20,000) = 70,000

Year 5 = (90,000-20,000) = 70,000

Year 6 = (90,000 + 3000 - 20,000) = 73,000

IRR = Present Value of all cash flows - Initial Investment

  

Initial Investment = 300,000

​Present Value Year 1 = 70,000/1.1 = 63636.3636364

​Present Value Year 2 = 70,000/1.12 = 57851.2396694

​Present Value Year 3 = 70,000/1.13 = 52592.0360631

​Present Value Year 4 = 70,000/1.14 = 47810.9418756

​Present Value Year 5 = 70,000/1.15 = 43464.4926141

​Present Value Year 6 = 73,000/1.16 = 41206.5968939

IRR = Sum of Present Values - Initial Investment

       = 0.10740

IRR = 10.740%

Since IRR is more than the MARR this offer should be selected as this is feasible for the Manager.

This suggestion would influence the decision of the manager in a way that even though the annual maintenance charge will be applied from the first year itself in this offer the expected rate of return is more than the Minimum acceptable rate of return he should consider taking it as it is feasible for him.