Question

Harding Company is in the process of purchasing several large pieces of equipment from Danning Machine Corporation. Several financing alternatives have been offered by Danning: ((FV of $1, PV of $1, FVA of $1, PVA of $1, FVAD of $1 and PVAD of $1) (Use appropriate factor(s) from the tables provided.)

1. Pay $1,180,000 in cash immediately.
2.Pay $481,000 immediately and the remainder in 10 annual installments of $98,000, with the first installment due in one year.
3. Make 10 annual installments of $162,000 with the first payment due immediately.
4. Make one lump-sum payment of $1,770,000 five years from date of purchase.

Required:
Determine the best alternative for Harding, assuming that Harding can borrow funds at a 8% interest rate. (Round your final answers to nearest whole dollar amount.)

Answer 1

Answer: We will have to calculate the present value of all the alternatives available. The lowest present value option will be the best for us.

Present value formula = Cash flow /.(1+ discount rate)^ (no of period)

1. Present value of this option is $1,180,000 only.

2. Using the present value formula given above.

Discount rate is 8% will be same as borrowing rate

year	0	1	2	3	4	5	6	7	8	9	10
Cash flow	481000	98000	98000	98000	98000	98000	98000	98000	98000	98000	98000
Present value	481000	90740.74	84019.2	77795.56	72032.93	66697.15	61756.62	57182.06	52946.35	49024.4	45392.96
Net Present value	1138588

So, Present value is 1,138,588

Option 3 :

Using the present value formula given above.

Discount rate is 8% will be same as borrowing rate

year	0	1	2	3	4	5	6	7	8	9
Cash flow	162000	162000	162000	162000	162000	162000	162000	162000	162000	162000
Present value	162,000	150,000	138,889	128,601	119,075	110,254	102,087	94,525	87,524	81,040
Net Present value	1,173,996

So, Present value is 1,173,996

Option 4:present value of this option will be

Present value * (1+discount rate) ^(no of years) = Future value

lets take present value as X

X*(1+0.08) ^5 = 1,770,000

X = 1,770,000/ 1.469

X = 1204632.3

Out of all these 4 options Option 2 is the one where we have the lowest present value.

So, option 2 we should choose for the payment