Problem:
Proust Manufacturing Co. produces personal fitness machines sold through infomercials. The once successful line is no longer selling well, so the company is considering production of a new improved cardio-vascular machine. The project's expected after tax cash flow is given below. The after tax cash flow at time zero, $-700,000, is the cost of equipment. As an alternative, rather than purchase the equipment, Proust can instead lease it for four equal annual payments of $185,000 paid at the beginning of each year. The required rate of return (hurdle rate) for this business is 11 percent.
Time After Tax
Cash Flow (net)
Year 0 -700,000
Year 1 375,000
Year 2 250,000
Year 3 140,000
Year 4 75,000
Required:
Calculate the net present value of both the new production option and of the lease option. Determine the best option for Proust and justify your answer.