Question

In the Table below is information about two options that face the Alpha & Omega Company as it seeks to expand its operations. Note that  all cash flows are at the end of the year except for the initial costs.

	Option 1	Option 2
Initial cost	$680,000	$720,000
Usage life	5 years	6 years
Salvage value at end of useful life	$20,000	$30,000
Cash flows (excluding salvage value):
Year 1	$140,000	$ 80,000
Year 2	$140,000	$180,000
Year 3	$140,000	$280,000
Year 4	$140,000	$380,000
Year 5	$140,000	$260,000
Year 6	$     -	$150,000
Depreciation method is straight line
Tax rate is	20%	20%
Company’s cost of capital	12%	12%

Present value of $1.00

	Rate per period
Periods	6%	12%
1	0.9434	0.8929
2	0.8900	0.7972
3	0.8396	0.7118
4	0.7921	0.6355
5	0.7473	0.5674
6	0.7050	0.5066
7	0.6651	0.4524

Present value of Ordinary Annuity of $1.00

	Rate per period
Periods	6%	12%
1	0.9434	0.8929
2	1.8334	1.6900
3	2.6730	2.4018
4	3.4651	3.0373
5	4.2124	3.6048
6	4.9173	4.1114
7	5.5824	4.5638

1 Calculate the net present value for each option.

2 Calculate the payback period for each option

3. Based on the results in (a) and (b) what course of action would you recommend to the management of Alpha & Omega Company?

Answer 1

1.

	Cash Flows			Present Value of Cash Flow
	Option 1	Option 2	PV Factor@12%	Option 1	Option 2
Initial cost	$        -6,80,000	$         -7,20,000	1	$    -6,80,000.00	$       -7,20,000.00
Year 1	$          1,40,000	$              80,000	0.8929	$      1,25,006.00	$            71,432.00
Year 2	$          1,40,000	$          1,80,000	0.7972	$      1,11,608.00	$         1,43,496.00
Year 3	$          1,40,000	$          2,80,000	0.7118	$          99,652.00	$         1,99,304.00
Year 4	$          1,40,000	$          3,80,000	0.6355	$          88,970.00	$         2,41,490.00
Year 5	$          1,56,000	$          2,60,000	0.5674	$          88,514.40	$         1,47,524.00
Year 6	-	$          1,74,000	0.5066		$            88,148.40
NPV				$    -1,66,249.60	$         1,71,394.40

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	Option 1	Option 2
	156000=140000+16000	174000=150000+24000
Salvage Value (after tax)	$              16,000	$              24,000
	20000*(1-0.20)	30000*(1-0.20)

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2.

	Cash Flows		Cumulative Cash Flow		Payback period
	Option 1	Option 2	Option 1	Option 2	Option 1	Option 2
Year 1	$        1,40,000	$           80,000	$         1,40,000	$          80,000
Year 2	$        1,40,000	$        1,80,000	$         2,80,000	$       2,60,000
Year 3	$        1,40,000	$        2,80,000	$         4,20,000	$       5,40,000
Year 4	$        1,40,000	$        3,80,000	$   5,60,000.00	$       9,20,000		3.47 Years
Year 5	$        1,56,000	$        2,60,000	$         7,16,000	$    11,80,000	4 .77 years
Year 6	-	$        1,74,000		$    13,54,000
	$        7,16,000	$     13,54,000
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Initial cost	$        6,80,000	$        7,20,000
Payback Period	Time at which cumulative cash flow equals initial investment
	4 .77 years	3.47 Years
	4 year + [(680000-560000)/156000]	3 year + [(720000-540000)/380000]

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3.

Option-2 is Better, Because it has positive net present value, and also having less payback period compared to option 1

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Hope you Understood.
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Thank you.