Question

Nancy Houser has a debt of $1,500 for books and supplies at Ken’s Bookstore. She doesn’t want her parent to know about her debt. Ken’s Bookstore tells her that she can pay the debt in one of two ways: Alternative A: Pay $500 now and $1,200 in five years Alternative B: Pay $2,000 in five years Assuming that the interest rate to her is 12%, which alternative should she choose? Please specify whether you choose alternative A or B writing only the capital letter in the space provided. _________

Answer 1

Answer:

Alternative B

Calculation:

Here we need to determine the alternative Nancy Houser should she choose.

Alternative A: Pay $500 now and $1,200 in five years

First we need to find the Present value of $1,200 discounted @ 12% for 5 years.

For that we need to calculate the present value factor either using the table or using MS Excel or formula.

=PV(12%,5,0,1,0) = 0.567427

or using formula = 1/(1+12%)^5 = 0.567427

Then we need to multiply with $1200.

Present value of $1,200 discounted @ 12% for 5 years = 681

Then we need to add the Present value of $500 now which is 500 to the PV of 1200.

Present value of Alternative 1 = 681+ 500 = 1,181

Alternative B: Pay $2,000 in five years

First we need to find the Present value of $2000 discounted @ 12% for 5 years.

For that we need to calculate the present value factor either using the table or using MS Excel or formula.

=PV(12%,5,0,1,0) = 0.56743

or using formula = 1/(1+12%)^5 = 0.56743

Then we need to multiply with $2,000.

Present value of $2,000 discounted @ 12% for 5years ($2,000 × .56743) = 1,135

On the present value basis, Nancy should choose Alternative B as it has low cost.