Question

The CFO of Roland GmbH wants to improve its new production plant and has two mutually exclusive alternatives to choose from:

1. The first option would be to enlarge the plant and buy a new building. This involves an initial cost of $3,000,000 and is expected to generate $150,000 a month in revenue for the next 2 years at a discount rate of 9% compounded annually.

2. Alternatively, the company could invest the $3,000,000 in the stock market at an expected return of 9% per year compounded annually.

Decide which is the best choice between A or B. Your result must be supported by using the correct capital budgeting model and calculating the results of both A and B.

Answer 1

The following table shows the calculation for the above two scenerios:

	Investment	30,00,000
Option 1
	Monthly Revenue	150000
	Discount rate	9%
	Year	1	2
	Revenue	18,00,000	18,00,000
	Value at end of year 2	37,62,000
Option 2	Discount rate	9%
	Value at the end of 2 years	35,64,300

As the return at the end of year 2 is greater in Option 1, Option 1 is the preferred option.