Question 2 Joe, a university student, wants to start a small-scale painting busi

Question

Question 2 Joe, a university student, wants to start a small-scale painting business during his out- of-class hours. To save money, he decides to purchase some used painting equipment. He will still need to borrow money to fund the purchase. He has two mutually exclusive options: Do most of the painting himself by limiting his business to only residential painting jobs (A1) or purchase more painting equipment and hire some other students to do both residential and commercial painting jobs that he expects will have a higher equipment cost, but provide higher revenues as well (A2). In either case, Joe expects to close the business in three years when he completes his course. The expected cash flows for the two mutually exclusive alternatives, net of tax, are as follows:

Explanation / Answer

We need to find interest rate at which NPV become zero or negative

NPV = CF0+CFn/(1+i)^n

NPVA1=-3000+(1350/(1+0.1)^1)+(1800/(1+0.1)^2)+(1500/(1+0.1)^3) = 0

NPVA2=-3000+(1350/(1+0.2)^1)+(1800/(1+0.2)^2)+(1500/(1+0.2)^3) = -14.679

Year A1 A2

0 -3000 -12000

1 1350 4200

2 1800 6225

3 1500 6330

IRR 25% 17%

So option A1 needs to be selected if interest rate is greater than 25% and option A2 if interest is greater than 17%

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