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1.

To calculate the preferred method, we calculate the incremental IRR for method A minus B,
B minus C, and A minus C. To figure out the preferred method, we estimate the MARR at 15%.
The cash flow for every option can be broken down into three components: an initial cost,
positive cash flow over a ten year period, and salvage revenue in ten years.

IRR of A-B:

⎡( 28,000 − 8,000 ) − ( 43,000 − 13,000 ) ⎤⎦ ⎛ 1 ⎞ 3,000 − 6,900


0 = ( −75,000 + 125,000 ) + ⎣ ⎜ 1− ⎟+
IRRA− B ⎜⎝ (1+ IRR )10 ⎟⎠ (1+ IRRA− B )10
A− B

IRR = 15.6% under this comparison, and since money is being borrowed (there is a positive
initial cash flow followed by negative cash flow), we choose Option B over Option A.

IRR of B-C:

⎡( 43,000 − 13,000 ) − ( 79,000 − 38,000 ) ⎤⎦ ⎛ 1 ⎞ 6,900 − 16,000


0 = ( −125,000 + 220,000 ) + ⎣ ⎜ 1− ⎟+
IRRB−C ⎜⎝ (1+ IRR )10 ⎟⎠ (1+ IRR )10
B−C B−C

IRR = 4.1% under this comparison, and since money is being borrowed (there is a positive
initial cash flow followed by negative cash flow), we choose Option B over Option C.

IRR of A-C:

⎡⎣( 28,000 − 8,000 ) − ( 79,000 − 38,000 ) ⎤⎦ ⎛ 1 ⎞ 3,000 − 16,000


0 = ( −75,000 + 220,000 ) + ⎜ 1− ⎟+
IRRA−C ⎜⎝ (1+ IRR )10 ⎟⎠ (1+ IRR )10
A−C A−C

IRR = 8.3% under this comparison, and since money is being borrowed (there is a positive
initial cash flow followed by negative cash flow), we choose Option A over Option C.

Under this equation, B is superior to both A and C. To confirm that B is the best choice, we find
the individual IRR of B to make sure it’s better than the Null alternative:

0 = −125,000 +
( 43,000 − 13,000) ⎛⎜ 1− 1 ⎞
⎟+
6,900
⇒ IRRB = 20.4%
⎜⎝ ( B) ⎠
⎟ ( B)
10 10
IRRB 1+ IRR 1+ IRR
The IRR of B is 20.4%, while the MARR is 15%. Since this is an investment opportunity (the
company pays an initial cost and gets positive cash afterwards), Option B is superior to the null
alternative. Therefore, the company should pick Option B.

2. For this problem, all “Present Day” costs and values are taken at year 1 (or month 12), since
the first 12 payments have already passed. To figure out what the monthly payments are, we
use the perpetuity formula to figure out what 24 payments should be with 12% APR
compounded monthly to get a present value of $10,000:

⎛ ⎞
⎜ ⎟
A ⎜ 1 ⎟ ⇒ A = 470.74
10,000 = 1−
0.12 / 12 ⎜ ⎛ .12 ⎞ 24 ⎟
⎜ ⎜ 1+ ⎟
⎝ ⎝ 12 ⎟⎠ ⎠

For a loan of 800 dollars, the present value at the time of the loan is still 800 dollars, so the
compounding has no bearing on result of the issue. To see if the loan should be taken, we find
the present day cost of the final two payments and see if they exceed the 800 dollars that must
be paid to get rid of them:

470.74 470.74
Present Cost last _ two _ months = 11
+ 12
= 839.69
⎛ 0.12 ⎞ ⎛ 0.12 ⎞
⎜⎝ 1+ 12 ⎟⎠ ⎜⎝ 1+ 12 ⎟⎠

NPV pay _ 800 = 839.69 − 800 = 39.69

Since the present day cost of the last two payments, at $839.69, exceeds $800, the company
should borrow the money and take the deal.

b) From part a, we already know that spending a present day value of $800 to void the final two
payments is a good deal, because the present day cost of the final two payments is $839.69.
The instructions are really unclear, so we assume that the investment is $800 and pays 2%
of that $800 forever (a perpetuity), with the discount rate being the interest rate:

0.02 ⋅800
NPVinvestment = = 1600 − 800 = 800
0.12 / 12

NPVinvestment − NPV pay _ 800 = 800 − 39.69 = 760


The net present value of the investment outweighs that of paying 800. Therefore, the
company take the investment.

c) We designate our there options by letter: do nothing and make the final two payments (A),
pay the bank $800 (B), and make an $800 investment ( C ). To find the IRR, we compare the
$800 payment to doing nothing and to taking the investment, for all Minimum Acceptable
Rates of Return r, with the following formulas to find the comparative NPW’s:

NPWA = 800
470.74 470.74
NPWB = +
(1+ r ) (1+ r )
11 12

0.02 ⋅800
NPWC =
r

The graph is displayed below:

According to the graph, you should never take the $800 that the bank offers. However, we can
find the IRR’s for B nonetheless:

470.74 470.74
NPVB− A = + − 800 = 0 ⇒ IRRB− A = 1.42%
(1+ IRRB− A ) (1+ IRRB− A )
11 12

470.74 470.74 0.02 ⋅800


NPVB−C = + − = 0 ⇒ IRRB−C = 2.1%,27%
(1+ IRR ) (1+ IRR )
11 12
IRRB−C
B−C B−C

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