Question

Daryl Kearns saved $220,000 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 $183,500. The following table presents the estimated cash inflows for the two alternatives:

  

	Year 1			Year 2			Year 3			Year 4
Opportunity #1	$	55,665		$	58,890		$	78,900		$	101,440
Opportunity #2		103,200			109,000			17,200			15,600

  

Mr. Kearns decides to use his past average return on mutual fund investments as the discount rate; it is 8 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.)

  

Required

1. Compute the net present value of each opportunity. Which should Mr. Kearns adopt based on the net present value approach?

2. Compute the payback period for each opportunity. Which should Mr. Kearns adopt based on the payback approach?

Answer 1

Solution a:

Computation of NPV - Daryl Kearns
			Opportunity 1		Opportunity 2
Particulars	Period	PV Factor	Amount	Present Value	Amount	Present Value
Cash outflows:
Cost of Equipment	0	1	$183,500	$183,500	$183,500	$183,500
Present Value of Cash outflows (A)				$183,500		$183,500
Cash Inflows
Year 1	1	0.92593	$55,665.00	$51,542	$103,200.00	$95,556
Year 2	2	0.85734	$58,890.00	$50,489	$109,000.00	$93,450
Year 3	3	0.79383	$78,900.00	$62,633	$17,200.00	$13,654
Year 4	4	0.73503	$101,440.00	$74,561	$15,600.00	$11,466
Present Value of Cash Inflows (B)				$239,225		$214,126
Net Present Value (NPV) (B-A)				$55,725		$30,626

Mr. Kearns should adopt opportunity 1.

Solution b:

Computation of Cumulative Cash flows
Period	Opportunity 1		Opportunity 2
	Cash inflows	Cumulative Cash Inflows	Cash inflows	Cumulative Cash Inflows
1	$55,665.00	$55,665.00	$103,200.00	$103,200.00
2	$58,890.00	$114,555.00	$109,000.00	$212,200.00
3	$78,900.00	$193,455.00	$17,200.00	$229,400.00
4	$101,440.00	$294,895.00	$15,600.00	$245,000.00

Payback period - Opportunity 1 = 2 years + ($183,500 - $114,555) / $78,900 = 2.87 years

Payback period - Opportunity 2 = 1 year + ($183,500 - $103,200) / $109,000 = 1.74 years

Opportunity 2 should be adopted based on payback period.