Question

In: Economics

John has purchased some machinery for his company and has the choice of making payments as...

John has purchased some machinery for his company and has the choice of making payments as follows:

Option A: $10,000 now.

Option B: $6,000 now and $6,000 at the end of 10 years.

Option C: $ 2,500 now and $1000 at the end of each year for 10 years.

If the interest rate is 7%, which option would he select?

Expert Solution

I will calculate the present value of amount received in every option available, option with maximum present value will be selected.

Interest rate (r) = 7%

Option 1: Present value = 10,000

Option 2: 6,000 now

Presemt value of 6,000 at the end of 10 years [6,000 / (1 + 0.07)^¹⁰] = 3,050.09

Sum of present value of option 2 = 6,000 + 3,050.09 = 9,050.09

Option 3: 2,500 now

Present value of amount P at the end of each year can be calculated using formula: P * {[1 - (1 + r)^^-n] / r}

where n is number of payment received

Present value of annual payment: 1,000 * {[1 - (1 + 0.07)^^-10] / 0.07} = 7,023.58

Sum of present value = 2,500 + 7,023.58 = 9,523.58

Option 1 must be selected due to highest present value.

Rahul Sunny answered 2 years ago

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