Question

points Franklin Company plans to order and purchase some special drilling equipment that will be constructed and ready for service five years hence. If Franklin pays for the equipment upon completion (Plan A), it will cost $200,000. However, two alternative payment plans are available. Plan B would require an immediate payment of $110,000. Plan C would require five annual payments of $30,000, the first of which would be made one year hence. Assume an interest rate of 12% for each plan. Required Calculate the present value of each payment plan and indicate which plan Franklin should follow.

Answer 1

Calculation of the Present Value of each of the Payments : Plan A: Amount Payment Rate Discount Factor 200,000 After 5 Years 12% 0.567427 Present Value of the Payment = Amount * Discount Factor Plan C: Amount $ 30,000 Payment Yearly # of Payments = 5 Yearly Payments Determination of Present Value: Discount Discounted Year Amount Factor Cash Flow 30,000 0.89286 $ 26,785.71 $ 30,000 0.79719 $ 23,915.82 $ 30,000 0.71178 $ 21,353.41 $ 30,000 0.63552 $ 19,065.54 $ 30,000 0.56743 $ 17,022.81 Total Cash Outflow for Plan C $ 108,143.29 Present Value of the Payment = $ 200,000 * 0.567427 Present Value of the Payment = $ 113,485.40 Plan B : Amount 110,000 Payment Immediate Therefore, the present value of the payment = $ 110,000 Conclusion: Plan Plan A Plan B Plan C Amount of Cash Flow 113,485.40 $ 110,000.00 108,143.29 Since, the Outflow for the Plan C is minimum compared to the other plans. Franklin shall select the Plan C.