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 $1,343,000. The estimated net cash flows from each project are as follows:

	Net Cash Flow
Year	Office Expansion				Server
1	$338,000				$446,000
2	338,000				446,000
3	338,000				446,000
4	338,000				446,000
5	338,000
6	338,000

The committee has selected a rate of 10% 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 $423,000.

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 OFFICE EXPANSION / SERVER UPGRADE  has a higher net present value and would be a superior investment.

Answer 1

1
	Office Expansion	Server Upgrade
Present value of annual net cash flows	1471990	1413820
Less amount to be invested	1343000	1343000
Net present value	128990	70820
2
	Office Expansion	Server Upgrade
Present value of annual net cash flows	1360031	1413374
Less amount to be invested	1343000	1343000
Net present value	17031	70374
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.
Workings:
1
	Office Expansion	Server Upgrade
Present value of annual net cash flows	=338000*4.355	=446000*3.170
2
Office Expansion Year 4 cash flow	761000	=338000+423000
	Office Expansion			Server Upgrade
	Cash flows	PV factor	Present value	Cash flows	PV factor	Present value
1	338000	0.909	307242	446000	0.909	405414
2	338000	0.826	279188	446000	0.826	368396
3	338000	0.751	253838	446000	0.751	334946
4	761000	0.683	519763	446000	0.683	304618
		Total	1360031		Total	1413374