Rainbow Products is considering the purchase of a paint-making machine to reduce labor costs. The savings are expected to result in additional cash flows to Rainbow of $5000 per year.
The machine costs $35,000 and is expected to last for 15 years. Rainbow has determined that the cost of capital for such an investment is 12%.
Instead of the service contract, Rainbow engineers have devised a different option to preserve and actually enhance the capability of the machine over time.
By investing 20% of the annual cost savings back into new machine parts, the engineers can increase the cost savings at a 4% annual rate.
For example, at the end of year one, 20% of the $5,000 cost savings is reinvested in the machine; the net cash flow is thus $4,000. Next year the cash flow from cost savings grows by 4% to $5,200 gross, or $4,160 net of the 20% investment. As long as the 20% reinvestment continues, the cash flows continue to grow at 4% in perpetuity. What should Rainbow do?
What is NPV?
What is IRR?
What is payback?