Question

Mr. John Backster, a retired executive, desires to invest a portion of his assets in rental property. He has narrowed his choices to two apartment complexes, Windy Acres and Hillcrest Apartments. The anticipated annual cash inflows from each are as follows:

 

Windy Acres			Hillcrest Apartments
Yearly Aftertax Cash Inflow	Probability		Yearly Aftertax Cash Inflow	Probability
70,000	0.2		75,000	0.2
75,000	0.2		80,000	0.3
90,000	0.2		90,000	0.4
105,000	0.2		100,000	0.1
110,000	0.2

 

Mr. Backster is likely to hold the apartment complex of his choice for about 25 years and will use this period for decision-making purposes. Either apartment can be purchased for $200,000. Mr. Backster uses a risk-adjusted discount rate approach when evaluating investments. His scale is related to the coefficient of variation (for other types of investments, he also considers other measures).

 

Coefficient of Variation	Discount Rate
0–0.35	7%
0.35–0.40	10	(cost of capital)
0.40–0.50	14
Over 0.50	not considered

 

a. Compute the risk-adjusted net present value for Windy Acres and Hillcrest Apartments. (Do not round intermediate calculations. Round the final answers to nearest whole dollar.) (If you're using the TVM funtions of a calculator to answer the question, then you can ignore this note. If you're using the PV tables at the back of the book to answer this question, round "PV Factor" to 3 decimal places.)

 

	Net present value
Windy Acres	$
Hillcrest Apartments	$

 

b-1. Which investment should Mr. Backster accept if the two investments are mutually exclusive?

 

multiple choice 1

• Hillcrest

• Windy Acres

• Both

• None

 

b-2. Which investment should Mr. Backster accept If the investments are not mutually exclusive and no capital rationing is involved?

 

multiple choice 2

• Windy Acres

• Hillcrest Apartments

• Both

• None

Answer 1

Determination of Annual cashflow : Windy Hillcrest Cash Expected Cash Probability Probability Cash flows ($) Probability Flowe - Flows ($) Expected Cash flows $ flows $ 0.20 0.20 0.20 0.20 0.20 70,000 75,000 90,000 1,05,000 1,10,000 Total 14,000 15,000 18,000 21,000 22,000 90,000 0.20 0.30 0.40 0.10 75,000 80,000 90,000 1,05,000 15,000 24,000 36,000 10,500 Total 85,500

Determination of Net Present Value at 10% ! Windy Acres Year PVF @10% Cash Present flows $ Value $ Hillcrest Apartments Cash Present flows $ Value $ O 8 9 1.000 (2,00,000) 0.909 90,000 0.826 90,000 0.751 90,000 0.683 90,000 0.621 90,000 0.564 90,000 0.513 90,000 0.467 90,000 0.424 90,000 0.386 90,000 0.350 90,000 0.319 90,000 0.290 90,000 0.263 90,000 0.239 90,000 0.218 90,000 0.198 90,000 0.180 90,000 0.164 90,000 0.149 90,000 0.135 90,000 0.123 90,000 0.112 90,000 0.102 90,000 0.092 90,000 Net Present Value (2,00,000) 81,818 74,380 67,618 61,471 55,883 50,803 46,184 41,986 38,169 34,699 31,544 28,677 26,070 23,700 21,545 19,587 17,806 16,187 14,716 13,378 12,162 11,056 10,051 9,137 8,307 6,16,934 (2,00,000) 85,500 85,500 85,500 85,500 85,500 85,500 85,500 85,500 85,500 85,500 85,500 85,500 85,500 85,500 85,500 85,500 85,500 85,500 85,500 85,500 85,500 85,500 85,500 85,500 85,500 (2,00,000) 77,727 70,661 64,237 58,398 53,089 48,263 43,875 39,886 36,260 32,964 29,967 27,243 24,766 22,515 20,468 18,607 16,916 15,378 13,980 12,709 11,554 10,503 9,548 8,680 7,891 5,76,087 Net Present value of Windy Acres is $ 616,934/. Net Present value of Hillcrest Apartments is $ 576,087/. b-1) If projects are mutually exclusive, Project with Net present value is highest is selected. Hence project Windy acres is selected. b-2) If projects are not mutually exclusive, Both the projects can be accepted since both the projects have positive net present value.