24. A frozen foods distributor is evaluating two payment plans for purchasing machinery. Plan A involves making equal annual payments over five years, while Plan B requires a lump sum payment today. The distributor’s accountant has determined that an annual interest rate of 8% is appropriate for this analysis. How should the firm compare the two plans?
Answer: D
The firm should calculate the present value of the annuity for plan A and compare it to plan B.
To effectively compare the two payment plans, the firm needs to determine the present value of the annual payments in Plan A, as this allows for a direct comparison with the lump sum payment in Plan B.
A) Calculate the future value of plan B and compare it to plan A.
Calculating the future value of Plan B is not appropriate for this comparison because the firm needs to assess the cost of the payments relative to today’s value. Future value does not provide the necessary information to compare against the present value of the annuity in Plan A.
B) Calculate the present value of plan B and compare it to plan A.
While calculating the present value of Plan B could provide some insight, it is not the most relevant method for comparison. Since Plan A consists of multiple payments, the present value of the annuity in Plan A must be calculated to make an accurate comparison to the lump sum in Plan B.
C) Calculate the future value of the annuity for plan A and compare it to plan B.
Calculating the future value of the annuity for Plan A does not provide the correct basis for comparison. The focus should be on present values, as they reflect the amount that would need to be invested today to cover the future payments, making future value calculations irrelevant for this decision.
D) Calculate the present value of the annuity for plan A and compare it to plan B.
This option is the most appropriate as it allows the firm to understand how much the series of payments in Plan A is worth in today's terms. By calculating the present value of the annuity, the distributor can directly compare it to the lump sum payment required in Plan B.
Conclusion
The correct approach involves calculating the present value of the annuity for Plan A and comparing it to the lump sum payment in Plan B. This method provides a clear financial basis for understanding the costs associated with each payment plan, allowing for a sound decision based on present values rather than future projections. All other options fail to provide the necessary framework for an accurate comparison.