A company purchased an equipment with the initial cost of 50000$. The annual operating cost of the equipment is 9000$ per year. There is a major maintenance cost of 20000$ at 6th year. The salvage value of the equipment is 6000$. Find the net present value if the useful life of the equipment is 9 years, considering interest rate is 10%/year.
For an interest rate of 10 % the present value of the savings in M + R costs is: 10.1 600,5 + 2 10.1 600,5 = $5,091 + $ 4,628 = $ 9,719.
When the present values of the savings on M + R expenses are compared with the overhaul costs of $ 10,000 it is obvious that the overhaul investment is not a wise decision.
If, however, the interest rate is only 5 % then the present value of the savings on M + R expenditure is: 05.1 600,5 + 2 05.1 600,5 = $5,333 + $ 5,080 = $10,413.
In present dollars, which is more than the initial investment of $ 10,000, making the repair at the beginning the better option.
Compounding approach. Suppose that there is an opportunity to invest the $ 10,000 in a stock or a bond offering an annual rate of return equal to 10 % (after costs etc.). The future value is the initial investment plus the compounded interest earned. At the end of the first year, the future value will be $ 10,000 plus $1,000 in interest-earning (10%) = $11,000.
Assume (for simplicity) that the M + R extra costs are only paid once a year (at the end of the year); the balance after paying the bill for the extra M + R costs will be $ 11,000 - $ 5,600 = $ 5,400.