Use the following 5-step process in net present value analysis: Step 1. Select the discount rate.
Step 2. Identify the costs/benefits to be considered in analysis. Step 3. Establish the timing of the costs/benefits.
Step 4. Calculate net present value of each alternative. Step 5. Select the offer with the best net present value. This section will demonstrate the use of that 5-step process in two lease-purchase decision examples using nominal discount rates. You should follow the same steps for any net present value analysis whether you are using nominal discount rates or real discount rates. Lease-Purchase Decision Example 1. Assume that you want to determine which of the following proposals will result in the lowest total cost of acquisition? Offeror A: Proposes to lease the asset for 3 years. The annual lease payments are $10,000 per year. The first payment will be due at the beginning of the lease, the remaining two payments are due at the beginning of Years 2 and 3. Offeror B: Proposes to sell the asset for $29,000. It has a 3-year useful life. Salvage value at the end of the 3-year period, will be $2,000. Step 1. Select the discount rate. The term of the lease analysis is three years, so we will use the nominal discount rate for three years, 5.4 percent. Steps 2 and 3. Identify and establish the timing of the costs/benefits to be considered in analysis. The expenditures and receipts associated with the two offers and their timing are delineated in the table below: (Parentheses indicate a cash outflow.) |Offer-Related Expenditures/Receipts | |t |Offer A |Offer B | |0 |($10,000) |($29,000) | |1 |($10,000) |-0- | |2 |($10,000) |-0- | |3 |-0- |$2,000 |
Step 4. Calculate net present value. The tables below summarize the net present value calculations applied to each alternative. |Net present value of Offer A | |t |Cash Flow |DF |PV | |0 |($10,000) |1.0000 |($10,000) | |1 |($10,000) |0.9470 |($9,470) | |2 |($10,000) |0.8968 |($8,968) | |Net Present Value |($28,438) |
Note the following points in the net present value calculations above: o There are no cash inflows associated with Offer A, only outflows. o Payments due now are not discounted.
o Offeror A payments due at the beginning of Years 2 and 3 are treated as if they are due at the end of Years 1 and 2. o You could have calculated the net present value of Offer A using the Sum of Discount Factors (Appendix A-1) for the payments due at the beginning of Years 2 and 3. Remember that payments due now are not discounted and payments due at the beginning of Years 2 and 3 are treated as if they are due at the end of Years 1 and 2. The calculations would be: [pic]
|Net present value of Offer B | |t |Cash Flow |DF |PV | |0 |($29,000) |1.0000 |($29,000) | |3 |$2,000 |0.8492 |$ 1,698...