Question

Daryl Kearns saved $260,000 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 $184,000. The following table presents the estimated cash inflows for the two alternatives: Year 4 $101,350 15,600 Year 2 $58,750 109,650 Year 1 Year 3 Opportunity #1 Opportunity #2 55,720 103,500 $78,930 17,700 Mr. Kearns decides to use his past average return on mutual fund investments as the discount rate; it is 9 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.) Required a. 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 Mr. Kearns adopt based on the payback approach? Complete this question by entering your answers in the tabs below. Required A Required B Compute the net present value of each opportunity. Which should Mr. Kearns adopt based on the net present value approach? (Round your intermediate calculations and final answer to two decimal places.) Net Present Value .. Opportunity 1 Opportunity 2 Which opportunity should be chosen? <Required A Required B

Answer 1

Daryl Kearns - Part a - Calculation of Present Value Year Opp. 1 Discounting Factor PV of Cash flow 1 55720 0.9174 51117.528 12 58750 0.8417 49449.875 3 78930 0.7722 60949.746 4 101350 0.7084 71796.34 PV of total cash inflow = 233313.489 Less:- Investment = -184000 NPV = 49313.489 Part b - Opportunity 1 Payback = Initial Investment / Annual net cash inflow Initial Invstmt. Annual net cash inflow Unrecovered investment Year 1 184000 55720 128280 Year 2 58750 69530 Year 3 78930 Year 4 101350 193400 Payback period = 2 years +(69530 / 78930 ) = 2.88 years Year Opp. 2 Discounting Factor PV of Cash flow 1 103500 0.9174 94950.9 2 109650 0.8417 9 2292.405 3 17700 0.7722 13667.94 4 15600 0.7084 11051.04 PV of total cash inflow = 211962.285 Less:- Investment = -184000 NPV = 27962.285 Part b - Opportunity 2 Payback = Initial Investment / Annual net cash inflow Initial Invstmt. Annual net cash inflow Unrecovered investment Year 1 184000 103500 80500 Year 2 109650 Year 3 17700 Year 4 15600 230850 Opp. 1 should be adopted as it has higher NPV. Payback period =1 year +(80500 / 109650 ) = 2.73 years Opp. 2 should be adopted as it has lower payback period.