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 $1,428,000. The estimated net cash flows from each project are as follows:

	Net Cash Flow
Year	Office Expansion				Server
1	$375,000				$495,000
2	375,000				495,000
3	375,000				495,000
4	375,000				495,000
5	375,000
6	375,000

The committee has selected a rate of 12% 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 $469,000.

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) Calculation of Net Present Value (Amounts in $)

	Office Expansion	Server Upgrade
Annual net cash flows (A)	375,000	495,000
Relevant Present Value Annuity Factor	PVAF(12%, 6 yrs)	PVAF(12%, 4 yrs)
Present Value Factor (B)	4.111	3.037
Present value of annual net cash flows (A*B)	1,541,625	1,503,315
Less amount to be invested	1,428,000	1,428,000
Net present value	113,625	75,315

2) If the office expansion is adjusted to a four-year life, then the cash flow from residual value at the end of 4 years for office expansion would also be considered. Calculation of Present Value in this case is shown as follows:-

Calculation of Net Present Value (Amounts in $)

	Office Expansion	Server Upgrade
Annual net cash flows (C) (Except residual value)	375,000	495,000
Relevant Present Value Annuity Factor	PVAF(12%, 4 yrs)	PVAF(12%, 4 yrs)
Present Value Annuity Factor (D)	3.037	3.037
Present value of annual net cash flows (E = C*D)	1,138,875	1,503,315
Residual Value at the end of 4th year (F)	469,000	0
Present Value Factor (G)	0.636	0.636
Present Value of Residual Value (H = F*G)	298,284	0
Present value of net cash flow total (E+H)	1,437,159	1,503,315
Less amount to be invested	1,428,000	1,428,000
Net present value	9,159	75,315

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.