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

You decide to give the following options to the

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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
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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)
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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
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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’.
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