Question

Alternatives: purchase now for $200,000, or in 3 years at an estimated $340,000. MARR is 12% and inflation averages 6.75% per year.

▪ Without Inflation

▪ Inflation Considered

Answer 1

Ans.

a) Present value of Alternative 2 without taking inflation into consideration,

PV = 340000/(1+0.12)^3 = $242005.3

Thus, present value of alternative 2 is more than the present cost of $200000, so, alternative 1 should be chosen.

b) Present value of alternative 2 taking inflation into consideration,

PV = 340000/(1+0.12)^3 * (1+0.0675)^3

=> PV = $198939.581

Thus, alternative 2 should be chosen because alternative 2 has lower present value than the present cost of alternative 1.

Ans. Incremental cash flows in years,

Year 0 = -Purchase price (A - B) = -0.25 million or -250000

Year 1-5 = Net Annual Income (A-B) = 0.075 million or 75000

Year 6 = Net Annual Income (A-B) + Resale Value (A-B) = 0.275 million or 275000

Present worth of these cashflows at 15% interest rate,

PW = -250000 + 75000/(1+0.15) + 75000/(1+0.15)^2 + 75000/(1+0.15)^3 + 75000/(1+0.15)^4 + 75000/(1+0.15)^5 + 275000/(1+0.15)^6

=> PW = $120301.72 or 0.12 million

Thus, with positive incremental present worth, Property A should be chosen.

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