Question

Your company is interested in having a new facility constructed. The contractor expects that it will take approximately 3 years to complete the building. The contractor has offered you three payment plans for the building. They are as follows:
Time Plan 1 Plan 2 Plan 3 Today $2,112,000 $0 $3,168,000 1 year from now $6,864,000 $11,484,000 $0 2 years from now $6,864,000 $0 $10,032,000 3 years from now $6,864,000 $11,484,000 $10,032,000

The CFO of your company has asked you to provide recommendation concerning which payment plan to accept. What is your recommendation? Assume your weighted-average cost of capital is 16% and you have sufficient cash on hand to make any required payments today.

Answer 1

Answer:

Since the present value of plan 3 is the lowest ($14,698,697), then that is the best payment option.    

Explanation:

Time                               Plan 1                   Plan 2                    Plan 3

Today                          $2,112,000                 $0                $3,168,000

1 year from now         $6,864,000          $11,484,000               $0

2 years from now      $6,864,000                 $0                $10,032,000

3 years from now      $6,864,000           $11,484,000       $10,032,000

To determine which plan is better, we must calculate the present value of the cash flows and then choose the payment plan with the lowest value. We can use the excel PV function (r = 16%):

PV Plan 1 = $15,110,160  

PV Plan 2 = $14,876,994  

PV Plan 3 = $14,698,697

Since the present value of plan 3 is lowest, then that is the best payment option.