Question

1. You have just been hired as a consultant to help a firm to decide which of three options to take to maximize the value of the firm over the next three years. The following table shows year-end profits for each option. Interest rates are expected to be stable at 8 percent over the next three years. Option A B Profits in Year 1 $70,000 $50,000 $30,000 Profits in Year 2 $80,000 $90,000 $100,000 Profits in Year 3 $90,000 $100,000 $115,000 a. Discuss the difference in the profits associated with each option. b. Which option has the greatest present value?

Answer 1

a)

Option A total profit = 70,000+80,000+90,000 = 240,000

Option B total profit = 50,000 + 90,000 + 100,000 = 240,000

Option C total profit = 30,000 + 100,000 +115,000 = 245,000

difference between A and B = 240,000 - 240,000 = 0

difference between A and C = 245,000 - 240000 = 5000

Difference between B and C = 245000 - 240,000 = 5000

(above is the difference between overall profit over 3 years, alternatively, we can calculate yearly difference and compare )

b)

Option A has greatest present value.

Year Option A Option B Option CPV factor@8% Present value (A) Present value (B) Present value (C) 70000 50000 30000 0.925925926 64814.81481 46296.2963 27777.77778 90000 100000 0.85733882 68587.10562 77160.49383 85733.88203 90000 100000 115000 0.793832241 71444.90169 79383.2241 91290.70772 Total 204846.82 202840.01 204802.37