Question: A company is purchasing and installing a new machine. The combined purchase and installation cost is $25,000. Its maintenance cost is estimated to be $2,000 per year starting EOY 1 and increasing by 5% per year for 9 additional years. Revenue is estimated to be $10,000 per year starting EOY1 and continuing for 4 additional years. Revenue is estimated to increase to $12,000 starting EOY 6 and increasing by $1,000 each year for the next 4 years. The company's MARR is 15%.
After consultation with your boss the two of you discuss the fact that both PW and IRR calculations assume that cash flows expensed and cash flows received are all evaluated at the same interest rate. So after reviewing your calculated IRR, your discussion now turns to whether it feasible that your company can invest its revenues at IRR? You mutually agree that your computed IRR may not be realistic because the company can't invest its revenues at that rate. You decide to perform an External Rate of Return (ERR) using MARR.
a) What is your calculated ERR? Show all your work including your cash flow diagram.
b) How does calculated value of ERR compare to your previously calculated value for IRR?
c) Based on your ERR would you still recommend this project? If yes, what is your basis for recommending project approval?