Question

4

Daryl Kearns saved $240,000 during the 25 years that he worked for a major corporation. Now he has retired at the age of 50 and has begun to draw a comfortable pension check every month. He wants to ensure the financial security of his retirement by investing his savings wisely and is currently considering two investment opportunities. Both investments require an initial payment of $191,500. The following table presents the estimated cash inflows for the two alternatives Year 1 Opportunity #1 $ 55,675 Opportunity #2 104,400 Year 2 $ 58,870 109,500 Year 3 $78,790 17,600 Year 4 $101,320 15,700 Mr. Kearns decides to use his past average return on mutual fund investments as the discount rate, it is 9 percent. PV of Stand PVA of SD (Use appropriate factor(s) from the tables provided.) Required o. Compute the net present value of each opportunity. Which should Mr. Kearns adopt based on the net present value approach? b. Compute the payback period for each opportunity. Which should Me Kearns adopt based on the payback approach?

Answer 1

Net Present value = Present value of cash inflows – Present value of cash outflows

Opportunity 1 = 55,675*PVF(9%, 1 year) + 58,870*PVF(9%, 2 years) + 78,790*PVF(9%, 3 years) + 101,320*PVF(9%, 4 years)- 191,500

= 55,675*0.917 + 58,870*0.842 + 78,790*0.772 + 101,320*0.708 – 191,500

= $41,682.96

Opportunity 2 = 104,400*PVF(9%, 1 year) + 109,500*PVF(9%, 2 years) + 17,600*PVF(9%, 3 years) + 15,700*PVF(9%, 4 years)- 191,500

= $21,136.6

Choose Opportunity 1

Payback period is the time period in which The initial investment is receovered. Lower the better

Opportunity 1 Year Cash Flows Cumulative Cash Flows 0 -191,500 -191,500 1 55,675 -135,825 2 58,870 -76,955 3 78,790 1,835 4 101,320 103,155 Payback period = 2+ 76955/78790 = 2.98 years Opportunity 2 Year Cash Flows Cumulative Cash Flows 0 -191,500 -191,500 1 104,400 -87,100 2 109,500 22,400 3 17,600 40,000 4 15,700 55,700 Payback period = 1+ 87100/109500 = 1.80 years Choose Opportunity 2