Red River Corporation Is Considering the Purchase of New Equipment

question 78

Essay

Red River Corporation is considering the purchase of new equipment costing $500,000. The expected life of the equipment is 10 years. It is expected that the new equipment can generate an increase in net income of $60,000 per year for the next 10 years. The probabilities for the increase in net income depend on the state of the economy. $\begin{array}{lrrr}\text { Aftertax}&\text { Aftertax Probabilities}&\text { Net Income }\\\text { Recession } & .5 & (\$ 20,000) \\\text { Normal } & .3 & 40,000 \\\text { Boom } & .2 & 60,000\end{array}$
The equipment can be amortized using straight-line amortization for tax purposes. Red River's cost of capital is 14%. What is the expected NPV? Should they purchase the new equipment? Would your decision change if the cost of capital was 9%? Why or why not?

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