Question

In: Finance

Monash College is purchasing a new telephone system that will last for 4 years. It can...

Monash College is purchasing a new telephone system that will last for 4 years. It can purchase the system using one of the following two options

  • Option A: An up-front payment of $178,000
  • Option B: Monthly payment of $4000 with the first payment to be made now and the last payment to be made 47 months from now.

Question

  1. If Monash College can borrow at an annual percentage rate of 5% with monthly compounding, calculate and identify which option the Monash College should choose?
  2. In option B, if the monthly payments were made at the end of each month, without calculation briefly explain if your answer to part 2 a) would be different.

Solutions

Expert Solution

Part a.

We need to compare present value of both the options.

The Present value in option A is simply the Up-front cost of $178,000.

The Present value of option B = present value of annuity due of $4000 each for 47 months at interest rate of 5% p.a.

To find the present value of annuity, we can use manual formula

or we can also use the PV function of Excel or financial calculator as shwon below:

So the present value of that annuity is $171,125.60 which is less than option A. Thus Option B should be chosen.

Part b.

If the monthly payments were made at the end of each month, the present value of the option B would have been even lower, because at any positive rate of interest, same payments later in the time are worth less than those earlier in the time. Thus option B would still have remained the preferred choice.


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