Reconsider the lecture example regarding Middletown Community College. The colle

Question

Reconsider the lecture example regarding Middletown Community College. The college has decided not to rent vending machines but instead to buy them. X Company will sell machines to Middletown and promises to buy them back in five years. Assume that Middletown's annual profit equation for the snack operation is $0.09(X) - $54,400, where X is the number of snack items sold. Middletown expects to sell 760,000 snack items in each of the next five years. X Company is willing to negotiate the purchase price with Middletown, but it promises to purchase the machines back in five years for $3,500. Assuming Middletown wants a 7% return on this investment, what is the most they can pay for the vending machines?

Explanation / Answer

Solution:

Expected sales units of snack items = 760000

Expected annual profit = $0.09 * 760000 - $54,400 = $14,000

Repurchase price of machine after 5 years = $3,500

Expected return on investment = 7%

Maximum price that Middle town can pay for vending machine = Present value of annual cash flows discounted at 7%.

= $14,000 * cumulative PV factor for 5 periods at 7% + $3,500 * PV Factor for 5th period at 7%

= $14,000 * 4.100197 + $3,500 * 0.712986

= $59,898

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