Question

Alternative Capital Investments

The investment committee of Sentry Insurance Co. is evaluating two projects, office expansion and upgrade to computer servers. The projects have different useful lives, but each requires an investment of $1,310,000. The estimated net cash flows from each project are as follows:

	Net Cash Flow
Year	Office Expansion				Server
1	$366,000				$483,000
2	366,000				483,000
3	366,000				483,000
4	366,000				483,000
5	366,000
6	366,000

The committee has selected a rate of 15% for purposes of net present value analysis. It also estimates that the residual value at the end of each project's useful life is $0, but at the end of the fourth year, the office expansion's residual value would be $458,000.

Present Value of $1 at Compound Interest
Year	6%	10%	12%	15%	20%
1	0.943	0.909	0.893	0.870	0.833
2	0.890	0.826	0.797	0.756	0.694
3	0.840	0.751	0.712	0.658	0.579
4	0.792	0.683	0.636	0.572	0.482
5	0.747	0.621	0.567	0.497	0.402
6	0.705	0.564	0.507	0.432	0.335
7	0.665	0.513	0.452	0.376	0.279
8	0.627	0.467	0.404	0.327	0.233
9	0.592	0.424	0.361	0.284	0.194
10	0.558	0.386	0.322	0.247	0.162

Present Value of an Annuity of $1 at Compound Interest
Year	6%	10%	12%	15%	20%
1	0.943	0.909	0.893	0.870	0.833
2	1.833	1.736	1.690	1.626	1.528
3	2.673	2.487	2.402	2.283	2.106
4	3.465	3.170	3.037	2.855	2.589
5	4.212	3.791	3.605	3.352	2.991
6	4.917	4.355	4.111	3.784	3.326
7	5.582	4.868	4.564	4.160	3.605
8	6.210	5.335	4.968	4.487	3.837
9	6.802	5.759	5.328	4.772	4.031
10	7.360	6.145	5.650	5.019	4.192

Required:

If required, use the minus sign to indicate a negative net present value.

1. For each project, compute the net present value. Use the present value of an annuity of $1 table above. Ignore the unequal lives of the projects. If required, round to the nearest dollar.

	Office Expansion	Server Upgrade
Present value of annual net cash flows	$	$
Less amount to be invested	$	$
Net present value	$	$

2. For each project, compute the net present value, assuming that the office expansion is adjusted to a four-year life for purposes of analysis. Use the present value of $1 table above.

	Office Expansion	Server Upgrade
Present value of net cash flow total	$	$
Less amount to be invested	$	$
Net present value	$	$

3. The net present value of the two projects over equal lives indicates that the   has a higher net present value and would be a superior investment.

Answer 1

1
	Office Expansion	Server Upgrade
Present value of annual net cash flows	1384944	1378965
Less amount to be invested	1310000	1310000
Net present value	74944	68965
2
	Office Expansion	Server Upgrade
Present value of annual net cash flows	1307272	1379448
Less amount to be invested	1310000	1310000
Net present value	-2728	69448
3
The net present value of the two projects over equal lives indicates that the Server Upgrade has a higher net present value and would be a superior investment.
Workings:
1
	Office Expansion	Server Upgrade
Present value of annual net cash flows	=366000*3.784	=483000*2.855
2
Office Expansion year 4 cash flows	824000	=366000+458000
	Office Expansion			Server Upgrade
Year	Cash flows	PV factor	Present value	Cash flows	PV factor	Present value
1	366000	0.870	318420	483000	0.870	420210
2	366000	0.756	276696	483000	0.756	365148
3	366000	0.658	240828	483000	0.658	317814
4	824000	0.572	471328	483000	0.572	276276
		Total	1307272		Total	1379448