Peter wants to buy a computer which he expects to save him $4,000 each year in bookkeeping costs. The computer will last for five years, and at the end of five years it will have no salvage value. If Peter's required rate of return is 12%, what is the maximum price Peter should be willing to pay for the computer now?
A)$20,000
B)$14,420
C)$11,340
D)$10,830

Question

Quizplus · Accepted Answer

We can use the Present Value of an Annuity formula to calculate the maximum price Peter should be willing to pay:
PV = Annual savings x Present value factor
The annual savings is $4,000 and the present value factor can be found using the following formula:
PV factor = [1 - (1 + r)^-n] / r
where r is the required rate of return and n is the number of periods (years in this case).
PV factor = [1 - (1 + 0.12)^-5] / 0.12 = 3.6048
Therefore, the maximum price Peter should be willing to pay is:
PV = $4,000 x 3.6048 = $14,419.20
The closest answer choice is B.

Peter Wants to Buy a Computer Which He Expects to Save