Question

1. A company has the choice between two different types of dies. One cost less, but it also has a shorter life expectancy. The expected cash flows after taxes for the two different dies are as follows:

Die	0	1	2	3	4
A	(10,000)	8,000	8,000
B	(12,000)	5,000	5,000	5,000	5,000

The cost of money of the firm is 10%. Assume that the selected die will be used for many years to come. Analyze the two options and advise the company which one is better.

Answer 1

We can answer this question based on calculation NPV or Net Present Value of the die.

NPV = - Initial investment + Sum of the present value of future cash flows

Discount rate = 10% because thats the cost of the money of the firm.

NPV of die A = - 10000 + 8000/(1+10%)^1 + 8000/(1+10%)^2 =

NPV of die A = $3,884.30

NPV of die B = -12000 + 5000/(1+10%)^1 + 5000/(1+10%)^2 + 5000/(1+10%)^3 + 5000/(1+10%)^4

NPV of die B = $3,849.33

As NPV of die A is greater than NPV of die B hence, decision rule is select the higher NPV.

Better option is Die A.