Question

You are in the market for a new refrigerator for your company's lounge, and you have narrowed the search down to two models. The energy efficient model sells for $1700 and will save you $45 at the end of each of the next five years in electricity costs. The standard model has features similar to the energy efficient model but provides no future saving in electricity costs. It is priced at only $1500. Assuming your opportunity cost of funds is 6 percent, which refrigerator should you purchase?
Should you pick one of the three:

1. You should be indifferent between the two?

2. The standard model.

3. The energy efficient model?

Answer 1

Answer:

The answer is:

We should pick the energy efficient model as its net present value the choice brings about is higher than the standard model.

Explanation:

We apply the net present value (NPV) methodology to evaluate which model to be picked up. The option that resulting in higher NPV should be chosen.

+ The standard model's NPV is equal to its price which is $(1,500) as it has no energy cost-saving during its life time.

+ The energy efficient model's NPV is equal to the sum of its selling price and the net present value of the energy cost-saving for 60 months ( 12 months per year x 5 years of useful life), $45 each month, discounting at opportunity cost of 6%; which is calculated as below:

-1,700 + (45/6%) * [1 - 1.06^(-60)] = $(972.74).

=> So, the energy efficient model should be chosen because its NPV is higher than the standard model (  $(972.74) > $(1,500) ).