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 $185,000. The following table presents the estimated cash inflows for the two alternatives: Year 1 Year 2 Year 3 Year 4 Opportunity #1 $ 55,705 $ 58,770 $ 78,860 $ 101,390 Opportunity #2 102,900 108,850 17,700 14,300 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 Compute the net present value of each opportunity. Which should Mr. Kearns adopt based on the net present value approach? 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.

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

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

	Payback Period Opportunity 1 Opportunity 2 Which opportunity should be chosen?

Answer 1

A) Calculation of Net Present Value of Opportunity 1 (Amounts in $)

Year	Cash Inflows (i)	PVF@8% (ii)	PV of Cash Inflows (i*ii)
1	55,705	0.92593	51,578.93
2	58,770	0.85734	50,385.87
3	78,860	0.79383	62,601.43
4	101,390	0.73503	74,524.69
Present Value of Cash Inflows			239,090.92
Less: Initial Investment			185,000.00
Net Present Value			54,090.92

Therefore the net present value of opportunity 1 is $54,090.92.

Calculation of Net Present Value of Opportunity 2 (Amounts in $)

Year	Cash Inflows (a)	PVF@8% (b)	PV of Cash Inflows (a*b)
1	102,900	0.92593	95,278.20
2	108,850	0.85734	93,321.46
3	17,700	0.79383	14,050.79
4	14,300	0.73503	10,510.93
Present Value of Cash Inflows			213,161.38
Less: Initial Investment			185,000.00
Net Present Value			28,161.38

Therefore the net present value of opportunity 2 is $28,161.38.

As the net present value of opportunity 1 is more, Daryl Kearns should chose opportunity 1.

B) Calculation of Payback Period for Opportunity 1 (Amounts in $)

Year	Cash Inflows	Cumulative Cash Inflows
1	55,705	55,705
2	58,770	114,475
3	78,860	193,335
4	101,390	294,725

Payback period = 2 yrs + [(185,000-114,475)/78,860]

= 2 yrs + 0.89 yrs = 2.89 yrs

Calculation of Payback Period for Opportunity 2 (Amounts in $)

Year	Cash Inflows	Cumulative Cash Inflows
1	102,900	102,900
2	108,850	211,750
3	17,700	229,450
4	14,300	243,750

Payback period = 1 yr + [(185,000-102,900)/108,850]

= 1 yr + 0.75 yrs = 1.75 yrs

As the payback period is shorter for opportunity 2, Daryl Kearns should chose opportunity 2.