Engineering Economics Blog

Howard owns a small electronics repair shop. He wants to borrow $10,000 now and repay it over the next 1 or 2 years. He believes that new diagnostic test equipment will allow him to work on a wider variety of electronic items and increase his annual revenue. Howard received 2-year repayment options from banks A and B.


After reviewing these plans, Howard decided that he wants to repay the $10,000 after only 1 year based on the expected increased revenue. During a family conversation, Howard’s brother-in-law offered to lend him the $10,000 now and take $10,600 after exactly 1 year.

Now Howard has three options and wonders which one to take. Which one is economically
the best?
 
Solution

The repayment plans for both banks are economically equivalent at the interest rate of 5% per year. (This is determined by using computations that you will learn in Chapter 2.) Therefore, Howard can choose either plan even though the bank B plan requires a slightly larger sum of money over the 2 years.

The brother-in-law repayment plan requires a total of $600 in interest 1 year later plus the principal of $10,000, which makes the interest rate 6% per year. Given the two 5% per year options from the banks, this 6% plan should not be chosen as it is not economically better than the other two. Even though the sum of money repaid is smaller, the timing of the cash fl  ows and the interest rate make it less desirable.   The point here is that cash fl  ows themselves, or their sums, cannot be relied upon as the primary basis for an economic decision. The interest rate, timing, and economic equivalence must be considered.