Consider the following capital budgeting problem. The following two machines are mutually exclusive and the firm would keep reinvesting in whatever machine it buys. Machine A would be reinvested every 4 years, machine B every 3 years. The cash flows associated with each machine are tabulated as follows; all numbers are in thousand dollars; the relevant discount rate is 10% for both machines.
Year Machine A Machine B
0 -80 -100
1 50 60
2 50 60
3 50 60
4 25 -
1a. Which of the two machines is the better investment project? Analyze the question under the assumption that whatever machine the company buys has to be reinvested in perpetuity.
1b. Suppose machine A fits current technology, whereas machine B needs a one-time re-tooling for the company. These one-off installation costs would be $10,000 today. What is the optimal investment decision now?
1c. Suppose the firm has an old machine in place that would serve for another two years. They can postpone investing in either machine A or B and keep using this machine. When should they stop using the old machine? Cash flows for the old machine are:
Year Cash Flow
1 50
2 20
3 0
1d. Suppose the investment opportunity described above lasts only for 24 years. Recalculate your decision rule for questions 1.a and 1.b. What is the NPV of the optimal investment policy now?