You are considering two investment options. In option A, you have to invest $4,5
ID: 1143321 • Letter: Y
Question
You are considering two investment options. In option A, you have to invest $4,500 now and $800 three years from now. In option B, you have to invest $4,000 now, $1,300 a year from now, and $800 three years from now. In both options, you will receive four annual payments of $1,600 each. (You will get the first payment a year from now.) Which of these options would you choose based on (a) the conventional payback criterion, and (b) the present worth criterion, assuming 8% interest? Assume that all cash flows occur at the end of a year.
Explanation / Answer
Year
Option A
Option B
0
-4500
-4000
1
1600
-1300 + 1600=300
2
1600
1600
3
-800+1600=800
-800 + 1600 = 800
4
1600
1600
a. Conventional Payback period
Conventional Payback period is also called as simple payback period that ignores the time value of money.
Option A
Cash Flow
Net Cash Flow
Year 0
$-4,500.00
$-4,500.00
Year 1
$1,600.00
$-2,900.00
Year 2
$1,600.00
$-1,300.00
Year 3
$800.00
$-500.00
Year 4
$1,600.00
$1,100.00
Payback Period = 3 + 500/1600 = 3.31 years
Option B
Cash Flow
Net Cash Flow
Year 0
$-4,000.00
$-4,000.00
Year 1
$300.00
$-3,700.00
Year 2
$1,600.00
$-2,100.00
Year 3
$800.00
$-1,300.00
Year 4
$1,600.00
$300.00
Payback Period = 3 + 1300/1600 = 3.81 years
Select the Option A for less payback period in comparison to Option A
(b) Present worth, assuming 8% interest?
Option A
NPW = -4500 + 1600 (P/A, 8%, 2) + 800 (P/F, 8%, 3) + 1600 (P/F, 8%, 4)
NPW = -4500 + 1600 (1.783) + 800 (.7938) + 1600 (.7350)
NPW = 167.44
Option B
NPW = -4000 + 300 (P/F, 8%, 1) +1600 (P/F, 8%, 2) + 800 (P/F, 8%, 3) + (1600 P/F, 8%, 4)
NPW = -4000 + 300 (.9259) +1600 (.8573) + 800 (.7938) + 1600 (.7350)
NPW = -539.51
Select Option A because of positive NPW. The option B have a negative NPW.
Year
Option A
Option B
0
-4500
-4000
1
1600
-1300 + 1600=300
2
1600
1600
3
-800+1600=800
-800 + 1600 = 800
4
1600
1600
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