A manufacturing company of a mini-doughnut machine maker quoted a price for a cu

Question

A manufacturing company of a mini-doughnut machine maker quoted a price for a custom-designed doughnut machine to be delivered in 2017. Once purchased, the customer intends to place the machine in service in January 2018 and will use it for 7 years. The expected annual operating net cash flow is estimated to be $148,000. The expected salvage value of the equipment at the end of 7 years is 14.5% of the initial purchase price. To expect a 13% required rate of return on the investment, what is the maximum amount that should be spent on purchasing the doughnut machine? You do not need to consider taxes or depreciation for this problem

Explanation / Answer

Salvage value (S) = Purchase price (C) x 0.145

Purchase price will be at least equal to present worth (PW) of cash flows, as follows.

PW ($) = - C + 148,000 x P/A(13%, 7) + C x 0.145 x P/F(13%, 7)

= - C + 148,000 x 4.4226 + C x 0.145 x 0.4251 = - C + 654,545 + 0.0616C = 654,545 - 0.9384C

If purchase price is maximum, PW = 0

654,545 - 0.9384C = 0

0.9384C = 654,545

C = $697,541

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