Question

Daryl Kearns saved $250,000 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 $189,500. The following table presents the estimated cash inflows for the two alternatives:

  

	Year 1			Year 2			Year 3			Year 4
Opportunity #1	$	55,720		$	58,760		$	78,870		$	101,280
Opportunity #2		103,900			109,400			17,800			15,600

  

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

1. Compute the net present value of each opportunity. Which should Mr. Kearns adopt based on the net present value approach?

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

a

Net Present Value
Opportunity 1	not attempted
Opportunity 2	not attempted
Which opportunity should be chosen?

b

Payback Period
Opportunity 1	not attempted
Opportunity 2	not attempted
Which opportunity should be chosen?

Answer 1

Solution:

1) Computation of Net Present Value (N.P.V) of each Opportunity a) Opportunity #1 Statement Showing N.P.V Particulars Period P.V. Factor @8% Cash Flow Disc. Cash Flow Cash Outflow 1,89,500 -1,89,500 Cash Inflow 0.9259 55,720 51,591 0.8573 58,760 50,375 0.7938 78,870 62,607 0.735 1,01,280 74,441 N.P.V 49,514 b) Opportunity #2 Particulars Cash Outflow Cash Inflow Statement Showing N.P.V Period P.V. Factor @8% Cash Flow Disc. Cash Flow 1,89,500 -1,89,500 0.9259 1,03,9001 96,201 0.8573 1,09,400 93,789 0.7938 17,800 14,130 0.735 15,600 11,466 N.P.V 26,085 Conclusion: On the basis of above statement the Opportunity with higher Net Present Value should be adopted. Therefore, Opportunity #1 should be adopted.