Method A costs $80,000 initially and will have a $15,000 salvagevalue after 3 ye
ID: 1254402 • Letter: M
Question
Method A costs $80,000 initially and will have a $15,000 salvagevalue after 3 years. The operating cost with this method will be$30,000 per year. Method B has initial cost of $120,000, anoperating cost of$8,000 per year, and a $40,000 salvage value afterits 3-year life. At an interest rate of 12% per year, which methodshould be used on the basis of a present worth analysis?
Method A costs $80,000 initially and will have a $15,000 salvagevalue after 3 years. The operating cost with this method will be$30,000 per year. Method B has initial cost of $120,000, anoperating cost of$8,000 per year, and a $40,000 salvage value afterits 3-year life. At an interest rate of 12% per year, which methodshould be used on the basis of a present worth analysis?
Explanation / Answer
The way to think aboutthese problems is in both nominal and real terms. Nominalmeans the cash flow items as presented above, unadjusted for thetime value of money. Real means the cash flow recalculated toaccount for the time value of money. I calculated the realcash flows in today dollars below: Discount rate = 12% Year 0 Year 1 Year 2 Year 3 Salvage Total Method A Nominal Cash Flow (80,000) (30,000) (30,000) (30,000) 15,000 (155,000) Method A Real Cash Flow (80,000) (28,200) (24,600) (21,000) 9,600 (144,200) Method B Nominal Cash Flow (120,000) (8,000) (8,000) (8,000) 40,000 (104,000) Method B Real Cash Flow (120,000) (7,520) (6,560) (5,600) 25,600 (114,080) I assumed that operatingexpenses were incurred evenly through the year, and the salvagevalue occurred at the end of year three. This means that yearone operating expenses were discounted 6%, year two were discounted18%, year three, 30%. The salvage value was discounted36%. The purchase price, as it occurred in year zero, isundiscounted when converted from nominal to real terms. The cash flow associated with Method Bis better than Method A in both nominal and real terms.