You have just been offered a contract worth $ 1.12 million per year for 6 years. However, to take the contract, you will need to purchase some new equipment. Your discount rate for this project is 11.8 %. You are still negotiating the purchase price of the equipment. What is the most you can pay for the equipment and still have a positive NPV?
Let Cash Flows in Year n be denoted by CFn
Amount paid for equipment = CF0
Given,
CF1 = $1.12 m
CF2 = $1.12 m
CF3 = $1.12 m
CF4 = $1.12 m
CF5 = $1.12 m
CF6 = $1.12 m
Discount Rate = r = 11.8%
Present Value = NPV = ΣCFn/(1+r)n
=> NPV = -CF0 + 1.12/(1+0.1) + 1.12/(1+0.1)2 + 1.12/(1+0.1)3 + 1.12/(1+0.1)4 + 1.12/(1+0.1)5 + 1.12/(1+0.1)6
=> NPV = -CF0 + 4.88
For NPV > 0,
-CF0 + 4.88 > 0
=> CF0 < 4.88 m
Hence, The maximum we can pay is $ 4.88 m
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