The owner of Grandma's Applesauce is planning to retire after the coming year. She has to repay a loan of $50,000 plus 8 percent interest and must rely on cash flow from operations to do so. Cash flow from operations is uncertain; there is a 70% probability it will equal $65,000, and a 30% probability it will equal $45,000.

Assuming a tax rate of 0%, what is the owner's expected cash flow after debt service?

A. $9,000 B. $5,000 C. $11,000 D. $7,700

Option (B) $5,000

Explanation:

Data provided in the question:

Repayment of Loan = $50,000

Interest = 8%

Cash flow Probability

$65,000 70%

$45,000 30%

Tax rate = 0%

Now,

Interest on loan = 8% of $50,000

= $4,000

Expected value of cash flow = ∑[cash flow * Probability ]

= (0.7 * $65,000) + (0.3 * $45,000)

= $45,500 + $13,500

= $59,000

The owner's expected cash flow after debt service

= Expected value of cash flow - Interest on loan - Repayment of Loan

= $59,000 - $4,000 - $50,000

= $5,000

Hence,

Option (B) $5,000