You decide to give the following options to the customers Which option do you

# You decide to give the following options to the

• 14

This preview shows page 5 - 9 out of 14 pages.

You decide to give the following options to the customers. Which option do you think is the best for the customer? And for you? Option A: Pay in 5 equal yearly installments. Options B: Pay nothing for 5 five years, but make a lump sum payment at the end of the 5 th year. IE 492 Engineering Economics 5

Subscribe to view the full document.

ECONOMIC EQUIVALENCE EXAMPLE (CONT.) You can see from the above table that from a customer stand point, option A is better, as they would pay \$145.75 less than option B for the smartphone. But, from the company standpoint, options B is better as they would make \$145.75 more than option A with each financing transaction. Also, don’t forget, the present value of both the options is \$500. So both options are equivalent . IE 492 Engineering Economics 6 Option A Option B Financed Amount \$500.00 \$500.00 Rate of Interest 10% 10% Finance Duration (years) 5.00 5.00 Year1 \$131.90 \$0.00 Year2 \$131.90 \$0.00 Year3 \$131.90 \$0.00 Year4 \$131.90 \$0.00 Year5 \$131.90 \$805.25 Total \$659.50 \$805.25 For option A we consider the following: Uniform Capital Recovery Factor: A = P * (A/P,i%,n) = \$500 * (A/P,10%,5) For option B we consider the following: Single Payment Compound Amount Factor F = P * (F/P,i%,n) = \$500 * (F/P,10%,5)
COST OF CAPITAL Cost of Capital is defined as the opportunity cost of making a specific investment. Interest rate that we looked at thus far is a ‘Cost of Capital’ or an opportunity cost from a perspective of the bank. Think about it. Bank is willing to pay you ‘x%’ interest rate to persuade you to invest money with them. Therefore, this is the Cost of Capital for the bank. From a customer stand point, this is an option that is being evaluated by you. Why would you choose a specific investment vehicle? Cost of Capital also is proportionate to, and varies by the amount of risk. Higher the risk, higher the Cost of Capital and vice-versa. Typically when a company expands their operations the Cost of Capital is lower, as compared to when the company is diversifying their portfolio and entering into a new line of business. IE 492 Engineering Economics 7

Subscribe to view the full document.

CAPITAL & COST OF CAPITAL (CONT.) New business = high risk = high Cost of Capital. There are generally two ways to raise Capital. Debt Company borrows funds from external sources including financial institutions, issue bonds etc. Interest rate associated with such borrowing is called ‘Cost of Debt’.
• Summer '16

### What students are saying

• As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

Kiran Temple University Fox School of Business ‘17, Course Hero Intern

• I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

Dana University of Pennsylvania ‘17, Course Hero Intern

• The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

Jill Tulane University ‘16, Course Hero Intern