Question

"Motors R Us requires a specific painting process for one its automobiles that will be manufactured for exactly eight years. Three options are available. Neither option 2 nor option 3 can be repeated after its process life. However option 1 will always be available at the same cost during the period of eight years. Here are the options:
-Option 1 is to subcontract out the process at a cost of $115,000 per year.
-Option 2 costs $181,000 immediately and has annual operating and labor costs of $77,000 and a useful service life of eight years with a salvage value of $58,000.
-Option 3 costs $130,000 immediately and has annual operating and labor costs of $75,000 and a useful service life of five years with a salvage value of $16,000. For years six through eight, the firm will follow option 1.
Enter the ""net present cost"" for the option that you would recommend if i = 12.8%. Enter your answer as positive number."

Answer 1

Option2 is recommendable as the present value of cash outflow is lowest in this option i.e. $530,920.

The present value of cost in each option has been computed as follows:

OPTION 1: SUBCONTRACT
YEAR	ANNUAL PAYMENT	[email protected]%	PRESENT VALUE
1	115,000	0.887	101950
2	115,000	0.786	90382
3	115,000	0.697	80125
4	115,000	0.618	71033
5	115,000	0.548	62973
6	115,000	0.485	55827
7	115,000	0.430	49492
8	115,000	0.382	43876
	Total present value of cost		555658
OPTION 2: INITIAL COST OF $181,000
YEAR	ANNUAL PAYMENT	[email protected]%	PRESENT VALUE
0	181,000	1.000	181000
1	77,000	0.887	68262
2	77,000	0.786	60516
3	77,000	0.697	53649
4	77,000	0.618	47561
5	77,000	0.548	42164
6	77,000	0.485	37380
7	77,000	0.430	33138
8	19,000	0.382	7249
	Total present value of cost		530920
Here, the cash outflow in eighth year will be net of after salvage value of $58,000
OPTION3: INITIAL COST OF $130,000
YEAR	ANNUAL PAYMENT	[email protected]%	PRESENT VALUE
0	130,000	1.000	130,000
1	75,000	0.887	66,489
2	75,000	0.786	58,944
3	75,000	0.697	52,256
4	75,000	0.618	46,326
5	59,000	0.548	32,308
6	115,000	0.485	55,827
7	115,000	0.430	49,492
8	115,000	0.382	43,876
	Total present value of cost		535,518.00
Here, the cash outflow in fifth year will be $59,000 after netting off $16,000 of salvage value