Question

Stemway Company requires a new manufacturing facility. It found three locations; all of which would provide the needed capacity, the only difference is the price. Location A may be purchased for $500,000. Location B may be acquired with a down payment of $100,000 and annual payments at the end of each of the next twenty years of $50,000. Location C requires $40,000 payments at the beginning of each of the next twenty-five years. Assuming Stemway borrowing costs are 8% per annum, which option is the least costly to the company?

Answer 1

Answer:

Location C costs least to the company as it only costs $461,160

Explanation:

We will evaluate all the three proposals

Location A Cost = $500,000

Location B

Down payment = $100,000

Annual year end payment = $50,000 for upcoming 20 years

Present value @ 8% = (${\sum \frac{1}{(1+0.08){^1}}+ \frac{1}{(1+0.08){^2}}+ ........ \frac{1}{(1+0.08){^2^0}}}) \times 50,000$ = 9.818 X $50,000 = $490,900

Net Present Value = $100,000 + $490,900 = $590,900

Location C

Payment of $40,000 at the beginning of each year, which means first payment will not be discounted and remaining 24 payments will be discounted.

Thus Present Value = $40,000 +( ${\sum \frac{1}{(1+0.08){^1}}+ \frac{1}{(1+0.08){^2}}+ ........ \frac{1}{(1+0.08){^2^4}}}) \times 40,000$ = $40,000 + 10.529 X $40,000 = $40,000 + $421,160 = $461,160

Thus Location C costs least to the company as it only costs $461,160