You purchase special equipment that reduces defects by $10,000 per year on an item...?

Question

You purchase special equipment that reduces defects by $10,000 per year on an item. This item is sold on contract for the next five years. After the contract expires, the special equipment will save approximately $2,000 per year for 5 years. You assume that the machine has no market value at the end of 10 years. How much can you afford to pay for this equipment now if you require a 20% annual return on your investment? All cash flows are end-of-year amounts.

Answer 1

This is a present value question. What is the present value of an annuity, basically. So, you will have to break it down into two phases. You can do this a variety of ways. You could find the present value of 10,000 for five years and then 2000 for five years after that (some tricky math since you will have to subtract the first five years from it), or you can do 2000 for 10 years and 8000 for 5 years, which is how I will proceed. So, here is what you would do:

8,000*2.991+2000*4.192=23928+8384=$32,312.
Using the appropriate present value figures, you would be willing to pay $32,312 today for this equipment in order to yield you a 20% return.

Answer 2

In business, when you get a loan, the bank is in the hole and looking to the future when it will recover the loan with interest. When you buy something, you may have to wait 5 years to recover any money. Then if not you will have to get the money with better terms.