The B Company has a policy of requiring a rate of return on investment of 16%. Two investment alternatives are available but the company may choose only one. Alternative 1 offers a return of $50 000 after 4 years, $40 000 after 7 years, and $30 000 after 10 years. Alternative 2 will return the company $750 at the end of each month for 10 years.
To determine which investment alternative to choose, we need to calculate the present value of the cash flows for each option and compare them to the required rate of return of 16%.
For Alternative 1, we have three different cash flows occurring at different time periods. We can use the present value formula to calculate the present value of each cash flow. The present value formula is: PV = CF / (1 + r)^n, where PV is the present value, CF is the cash flow, r is the discount rate, and n is the number of time periods.
For the first cash flow of $50,000 after 4 years, the present value is: PV_1 = $50,000 / (1 + 0.16)^4.
For the second cash flow of $40,000 after 7 years, the present value is: PV_2 = $40,000 / (1 + 0.16)^7.
For the third cash flow of $30,000 after 10 years, the present value is: PV_3 = $30,000 / (1 + 0.16)^10.
To calculate the present value of Alternative 2, we need to convert the monthly cash flows to an equivalent annual cash flow. To do this, we multiply the monthly cash flow of $750 by 12 to get the annual cash flow of $9,000. Then we can calculate the present value using the formula: PV = CF / (1 + r)^n.
For Alternative 2, with an annual cash flow of $9,000 for 10 years, the present value is: PV_2 = $9,000 / (1 + 0.16)^10.
Now we can compare the present values of both alternatives to the required rate of return of 16%. If the present value is greater than the required rate of return, it means that the investment is more favorable.
Finally, compare the present values of Alternative 1 and Alternative 2. Choose the alternative with the higher present value, as this indicates a higher return on investment.