Final answer:
Forgoing maintenance expenses for equipment replacement is a good decision only if the firm's MARR is less than 15.09%. The IRR rule does not apply as there are no cash inflows to calculate an IRR. Option b) IRR rule does not work, positive NPW only if MARR < 15.09% is the correct option.
Step-by-step explanation:
The question asks whether forgoing maintenance expenses for three years and then spending $2 million on replacing failed equipment in year 4 is a good decision, considering the internal rate of return (IRR) rule and the minimum acceptable rate of return (MARR).
To answer this, we must compare the present value of the cost saved from not performing maintenance to the present value of the $2 million expenditure in year 4.
If the firm does not spend $400,000 each year for maintenance for three years, it can be considered as a saving. Then, the firm expects to spend $2 million in the fourth year. We would calculate the internal rate of return (IRR) that equates the present value of the saved costs with the future $2 million cost.
However, given that there are no cash inflows, only outflows, the IRR calculation does not apply here as it cannot be effectively computed when all net cash flows are negative.
If we assume a certain rate of return, often referred to as the MARR, we can calculate the net present value (NPW) of the maintenance decision. If the NPW is positive, this means forgoing maintenance saves more in present value terms than the future cost of replacing equipment, making it a good decision if the MARR is below the rate that makes NPW positive.
Using financial formulae, we find that the NPW is positive only if the MARR is less than 15.09%. Thus, forgoing maintenance is a good decision if the firm's MARR is < 15.09%.