Question

Prepare a 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

The best option is the third option because it has the lowest present value

Step-by-step explanation:

The best choice of the options can be found by calculating the present value of the options.

Present value can be calculated using a financial calculator.

The present value of the first option would be $600,000

Present value of the second option

Cash flow in year 0 = $200,000

Cash flow each year from year 1 to 12 = $65,000

I = 12%

Present value = $602,634.33

Present value of the third option

Cash flow each year from year 0 to 13 = $90,000

I = 12%

Present value = $596,535.14

To find the PV using a financial calacutor:

1. Input the cash flow values by pressing the CF button. After inputting the value, press enter and the arrow facing a downward direction.

2. After inputting all the cash flows, press the NPV button, input the value for I, press enter and the arrow facing a downward direction.

3. Press compute

I hope my answer helps you