W00MT.8
8. Your company is considering a new machine. The machine will generate an extra $13 million per year starting next year, but will require $2 million in maintenance every two years (starting 2 years from now and with the last payment in year 28). The machine has a 30-year life and will cost $100 million today. The correct discount rate for this investment is 14% per year. Is your recommendation to buy the machine or not? Justify your recommendation with the appropriate analysis. [8 pts]

The cash flows look like this:

0	1	2	…	26	27	28	29	30
-100	13	13		13	13	13	13	13
		-2		-2		-2

There are 2 annuities here. The first is a straight-up 30-year annuity of $13M per year. The second is an annuity with 14 payments of $2M, where the payments are made every other year. If the correct annual rate is 14%, then the effective two-year rate is ((1.14)^2)-1=0.2996 or 29.96%. We answer this problem by figuring PVs of the 2 annuities and then subtracting the initial cost of the machine.

NPV=-100+91.0346-6.5053 = -15.471, so we should NOT buy the machine because doing so would reduce the value of the company by over $15 million.

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