Question

Prepare a 1-2 page double spaced memo to the company president, John Smith (who has an engineering background but no financial or accounting training) recommending the best choice in the following scenario:

Smith Construction Inc. has just purchased several major pieces of road building equipment. Because the purchase price is so large, the supplier is giving Smith the option of choosing among three payment plans:

Option 1 - $600,000 immediately in cash;

Option 2 - $200,000 down payment now and $65,000 per year for each of the next 12 years beginning at the end of the current year;

Option 3 - $90,000 at the end of each of the next 14 years.

Please assume that the cost of capital for Smith Construction is 12%.

Answer 1

Option 1:

PV of Cash Outflows = 600,000 * 1 = $ 600,000

Total Present Worth of the option = $ 600,000

Option 2:

PV of down payment = 200,000 * 1 = 200,000

PV of Cash Outflows = 65000 * PVAF for 12% for 12 years = 65000 * 6.19 = $ 402,634.32

Total Present worth of the option = 402634.32 + 200,000 = $ 602,634.32

Option 3:

PV of the cash outflows = 90000 * PVAF for 12 % for 14 years = 90000 * 6.628 = $ 596,535.14

Total Present Worth of the option = $ 596,535.14

Therefore, Option 3 is Preferable as it has a less Present worth than other options.