Question

Your company must ensure the safety of its work force. Two plans are being considered for the next 10 years: (1) Install a high electrified fence around the property at a cost of $100,000. Maintenance and electricity would then cost $5,000 per year over the 10-year life of the fence. (2) Hire security guards at a cost of $25,000 paid at the end of each year. Because the company plans to build new headquarters with a "state of the art" security system in 10 years, the plan will only be in effect until that time. Your company's required rate of return is 15 percent for average projects, and that rate is normally adjusted up or down by 2 percentage points for high- and low-risk projects. Plan 1 is considered to be of low risk because its costs can be predicted quite accurately. Plan B, on the other hand, is a high-risk project because of the difficulty of predicting wage rates. What is the proper PV of costs for the better project?

Answer 1

The required rate of return for the company is 15% on average projects. The rate is 2% higher for the riskier Plan B i.e, 17% (15+2)%. The rate is 2% lower for low risk project Plan A i.e, 13% (15-2)%.

Discounting factor = 1 / (1+r)ⁿ

were, r = required rate of return

n = number of year

Present Value = Cash flow * Discounting Factor

Plan A :- Install a high electrified fence around the property.

The calculation for Plan A present value of cost is as follows :-

Thus, present value cost of installing a high electrified fence around the property is 1,27,131.22.

Plan B :- Hire security guards

The calculation for Plan B present value of cost is as follows :-

Thus, present value cost of hiring security guards is 1,16,465.09

Therefore, the plan with lower present value of cost is Plan B hiring security guards(1,16,465.09). Thus, Plan B even though has a high risk, is the better project of the given two projects.