30,000
40,000
50,000
60,000
Alternatively, it could contract with a specialist company that would keep contempoianeous records of inventory, handle the billing and payroll, and so on, at a fixed fee of $42,000 per annum. This fee would be payable at the end of the year, whereas the in-house alternative would involve cash outflows on a more or less daily basis throughout the year. Rather than invest the money in either alternative, Oxford could leave the money in bonds, where it is currently earning 15 percent interest per annum.
(a) Calculate the expected value of the in-house alternative.
(b) Calculate the expected present value of the in-house alternative.
(c) Calculate the expected present value of the outside contract alternative.
(d) Advise the management of Oxford Equipment which alternative you think they should select, making explicit any reservations that underlie your recommendation.
1-10. The manager of the Fearless Ambition Racing Team is faced with the following decision problem: There is one race left in the series, and his driver could win the championship with a win or a second placing in the final race. He is concerned that the engine of the race car may be a little “tired” and is considering either a complete rebuilding of the engine or the purchase of a new engine. There is uncertainty involved in both alternatives. In a complete rebuilding of the en- will varv. denendine unon the mechanical components that must be replaced after
buy new) will result in an engine of the same power and durability. Based on past experience, the following probability distribution of costs associated with each option has been established.
REBUILD | BUY NEW | ||
Cost ($) | Probability | Cost ($) | Probability |
25,000 | 0.05 | 35,000 | 0.05 |
30,000 | 0.15 | 36,000 | 0.10 |
35,000 | 0.40 | 37,000 | 0.30 |
40,000 | 0.25 | 38,000 | 0.35 |
45,000 | 0.10 | 39,000 | 0.15 |
50,000 | 0.05 | 40,000 | 0.05 |
If the team manager decides to rebuild the existing engine, the parts and labor expenses will be incurred more or less evenly throughout the next year, because he will be able to keep suppliers waiting for their money for various lengths of time, up to a maximum of twelve months. If he purchases the new engine, the supplier will give the team a special deal in lieu of direct sponsorship: payment for the engine itself ($35,000) can be deferred twelve months. The other expenses can be spread out over twelve months, as in the rebuild option. The opportunity interest rate is 14 percent per annum.
(a) What is the expected value of the costs for each option?
(b) What is the expected present value of the costs for each option?
(c) Which option should be selected? Explain.
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