Q.

12

You are in the market for a new refrigerator for your company’s lounge, and you have narrowed the
search down to two models. The energy-efficient model sells for $700 and will save you $45 at the end
of each of the next five years in electricity costs. The standard model has features similar to the energy-
efficient model but provides no future saving in electricity costs. It is priced at only $500. Assuming your
opportunity cost of funds is 6 percent, which refrigerator should you purchase?

solution:

PV= FV1/(1+i)1 + PV2/(1+i)2 +PV3/(1+i)3 +PV4/(1+i)4 +PV5/(1+i)5

PV= 45/(1+0.06)1 + 45/(1+0.06)2 + 45/(1+0.06)3 +45/(1+0.06)4 +

45/(1+0.06)5

PV= 45/(1.06)1 + 45/(1.06)2 + 45/(1.06)3 +45/(1.06)4 + 45/(1.06)5

PV= 45/1.06 + 45/1.12 + 45/1.19 + 45/1.26 + 45/1.34

PV = 42.45 + 40.18 + 37. 82 + 35. 71 + 33. 58

PV = $ 189. 74

Thus, although the energy efficient model claims to save $225 ($ 45×5=$ 225) over the next five years,
the present value of the future savings over the next five years is only $189.74.

$ 700- $ 189.74 = 510. 26

So, the second refrigerator which is priced at $500 is preferred.

4. A firm’s current profits are $400,000. These profits are expected to grow indefinitely at a constant
annual rate of 4 percent. If the firm’s opportunity cost of funds is 6 percent, determine the value of the
firm

a. The instant before it pays out current profits as dividends.

b. The instant after it pays out current profits as dividends.

solution:

a. The value of the firm before it pays out current dividends is:

PV firm= p0( 1+i/i-g)

PV firm= $ 400,000( 1+0.06)/0.06 - 0.04

PV firm= $ 400,000( 1.06)/0.02 )

PV firm= $ 21, 200,000

B. The value of the firm immediately after paying the dividends is:

PVE-dividend firm= p0 (1+g/i-g)

PVE-dividend firm=

$ 400,000( 1+0.04/ 0.06-0.04)

= $ 400,000( 1.04/ 0.02)

PVE-dividend firm= $ 20,800,000