Erin is considering investing in a new plant that is expected to bring in $1,000,000 in revenues per annum provided that it is adequately maintained. According to hired consultants, maintenance costs will start at $50,000 in the first year but are expected to rise at 5% for each subsequent year. All revenues and maintenance costs will occur at the end of the period (year). Erin's plan is to run the plant as long as annual revenues exceed maintenance costs (positive cash flow). Assume an annual interest rate of 6% per year and that the plant is operational right away.
a. Calculate the present value of revenues and the present value of maintenance costs. (Hint: you first need to find the last year of production that is the year (N) following the first year when revenues exceed maintenance costs.
b. Suppose the initial capital cost to build the plant is $12 million. Would you advise Erin to invest in the project?