Question

Jones Manufacturing Co. produces personal fitness machines. After five years, the once successful line is no longer selling well, so the company is considering production of an improved line of machines incorporating new computer technology. This can be done by buying needed production equipment. There is a six-month manufacturing, delivery, setup, and training delay before the equipment will be ready for production. The company wants to start producing the new line of fitness machines in January next year. Two options are available – lease or buy.

Buy Option – The entire purchase price of the production equipment is $700K and is due at the time of the order. The cost of capital for this purchase is 8%. Assume: (1) the equipment has no residual value at the end of the fifth year and (2) there are no taxes.

Lease Option – The total lease cost is $600K. A $50K deposit is due at the time of the order. The remaining portion of the first year’s lease payment ($70K) is due in January next year. The other four annual lease payments ($120K each) are due in January of production years 2, 3, 4, and 5. The cost of capital for leasing is 18%. Assume no taxes.

Revenue from sales of the new line of fitness machines is expected to be:

Year 1 - $600,000

Year 2 – $500,000

Year 3 – $300,000

Year 4 – $200,000

Year 5 – $100,000

Calculate IRR for each option?

Answer 1

1. Buy Option
	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Cash outflow	-$700,000
Cash inflow		$600,000	$500,000	$300,000	$200,000	$100,000
PV @ 8%		$555,556	$428,669	$257,202	$158,766	$79,383	(Formula: cash flow / (1+0.08)^Number of years
Sum of PV	$1,479,576
Initia Outlay	-$700,000
NPV	$779,576
IRR	58%	(Furmula in excel: IRR(C4:H5)
2. Lease Option
	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Cash outflow	-$50,000	-$70,000	-$120,000	-$120,000	-$120,000	-$120,000
Cash inflow		$600,000	$500,000	$300,000	$200,000	$100,000
PV inflow @ 18%		$555,556	$428,669	$257,202	$158,766	$79,383	(Formula: cash flow / (1+0.08)^Number of years
PV outflow @ 18%	-$50,000	-$59,322	-$86,182	-$73,036	-$61,895	-$101,695
Sum of inflow PV	$1,479,576
Sum of outflow PV	-$432,129
NPV	$1,047,447
IRR	26%	(Furmula in excel: IRR(C4:H5)