14. Two alternatives, A and B are under consideration. Both have a life of five
ID: 1215441 • Letter: 1
Question
14. Two alternatives, A and B are under consideration. Both have a life of five years. Alternative A need an initial investment of $17,000 and provides net revenues of $4,000 per year for five years. An alternative B requires an investment of $19,000 and has annual net revenues of $5,000. All investments are in actual dollars. Inflation is expected to be 2% per year for the next five years, and the inflation-free (real) MARR is 9.8% per year. Which alternative should be chosen? a. Neither alternative b. Alt. A c. Alt. B 15. The expected inflation rate is estimated to be 9% per year, if you want to receive a 7% inflation-free return on your investment, what actual interest rate must you earn? d. 9% e. -2% c.1% b. 16%. a. 7%Explanation / Answer
14. Real MARR = 9.8%
To calculate market MARR the formula is:
Real MARR = Market MARR – Inflation rate / (1 + Inflation rate)
0.098 = Market MARR – 0.02 / (1 + 0.02)
0.098 = Market MARR – 0.02 / 1.02
0.098 x 1.02 = Market MARR – 0.02
Market MARR – 0.02 = 0.099
Market MARR = 0.099 + 0.02 = 0.119 or 11.9%
Now let us compare alternatives:
Alternative A - Cost Benefit Ratio:
Cost = $17,000
Benefits = $4,000(P/A,11.9%,5)
Benefits = $4,000*3.6137 = $14,454.8
Benefit / Cost = $14,454.8 / $17,000 = 0.85.
Alternative B - Cost Benefit Ratio:
Cost = $19,000
Benefits = $5,000(P/A,11.9%,5)
Benefits = $5,000*3.6137 = $18,068.5
Benefits / Cost = $18,068.5 / $19,000 = 0.95
Since Benefit to Cost ratio is higher for alternative B, alternative B should be chosen.
.15. Expected inflation rate = 9%
Real MARR = 7%
Real MARR = Market MARR – Inflation rate / (1 + Inflation rate)
0.07 = Market MARR – 0.09 / (1 + 0.09)
0.07 x 1.09 = Market MARR – 0.09
Market MARR – 0.09 = 0.0763
Market MARR = 0.0763 + 0.09 = 0.166 or 16.6%
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