Page 149 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes Solution:
1. Nest Present Value Method:
Cash inflow after taxes Total Present Value
Year's Deluxe Model Economy Model PV Factor Deluxe Model Economic Model
10%
1 - 5 9,000 6,000 3.7907 34,116 22,744

Deduct initial cost 30.000 20.000
Net Present Value 4,116 2,744
Hence, the model that gives higher NPV should be chosen i.e. Deluxe Model.
Remark: Since capital outlay was higher for Deluxe Model it has given higher NPV.

2. Present Value Index:
Deluxe Model Economy Model
34,116 22,744
30,000 20,000
= 1.1372 1.1372
Since both give same PI Index, we are indifferent as to both the models.

3. IRR:
Deluxe Model Economy Model
30,000 20,000
9,000 6,000
= 3.33 years = 3.33 years
Decision: If the capital is adequate there are no constraints, the proposal that gives higher NPV
should be selected. In this case, the Deluxe Model.
Problem 3: The High Peaks Sporting Goods Stores have been plagued by numerous burglaries
over the last 3 years. To keep insurance premiums at reasonable level and protect 10,00,000
inventory, the store fixed a night watchman. The watchman has solved the burglary problem,
but he costs the firm 12,000 a year.
He is occasionally absent from work due to sickness or bad weather. A security system company
has offered to sell the store system that would eliminate the need for the night watchman. The
system has an expected useful life of 15 years. The security system's salesperson is computing
the cost of the system and will present a bid this week. The management estimates cost of capital
at 16%.
Required:
1. What is the maximum bid the store should accept?

2. If the bid is 64,000 should the store accept?
3. If the actual life of the security system is 12 years instead of 15, does it have any effect on
your answer in part (b)?

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