Consider two options to buy equipment for your emergency department. You are given the choice to pay $15,000 in cash now, or pay zero upfront, but make four payments of $5,000. If the cost of capital is 2.5%, which is the best based on NPV?
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2What frequency are the payments to be made? Annually? Quarterly? Daily?– quidJun 26, 2019 at 19:13
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My professor didn't provide me with that information but let's say it's annually.– user87482Jun 26, 2019 at 19:15
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5What answer did you get when you* plugged these numbers into the NPV formula? Please show your work!– RonJohnJun 26, 2019 at 20:16
1 Answer
This might help illustrate the solution. I look at NPV of each cash flow. i.e. take each payment and calculate the PV of that future amount. $5000/1.025 means that $5000 in a year is worth $4878 if discounted by the 2.5%. The effect compounds, (1.025)^2 for year 2 etc.
At a glance, a total $20K would require a far higher cost of capital to make those payments preferable to the $15K lump sum.
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1Looks like the interest rate would need to be 12.59% or so in order for the two to be comparable.– Peter K.Jun 27, 2019 at 2:39