Question

The investment committee of Safe Hands Insurance Co. is evaluating two projects. The projects have different useful lives, but each requires an investment of $225,000. The estimated net cash flows from each project are as follows:

 

 

The committee has selected a rate of 12% 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, Project I's residual value would be $150,000.

Instructions
1. For each project, compute the net present value
. Use the present value of an annuity of $1 table appearing in this chapter. (Ignore the unequal lives of the projects.)
2. For each project, compute the net present value
, assuming that Project I is adjusted to a four-year life for purposes of analysis. Use the present value of $1 table appearing in this chapter.
3. Prepare a report to the investment committee, providing your advice on the relative merits of the twoprojects.

Answer 1

1.    Net present value analysis:

        Project I:

        Annual net cash flow (at the end of each of 6 years).....................................            $    70,000

        Present value of an annuity of $1 at 12% for 6 years (Exhibit 2)...................            .     4.111

        Present value of annual net cash flows...........................................................             $287,770

        Less amount to be invested.............................................................................                225,000

        Net present value.............................................................................................            $    62,770

 

        Project II:

        Annual net cash flow (at the end of each of 4 years).....................................            $    98,000

        Present value of an annuity of $1 at 12% for 4 years (Exhibit 2)...................            .     3.037

        Present value of annual net cash flows...........................................................             $297,626

        Less amount to be invested.............................................................................                225,000

        Net present value.............................................................................................            $    72,626

 

2.   

 3.    To: Investment Committee

       Both Projects I and II have a positive net present value. This means that both projects meet our minimum expected return of 12% and would be acceptable investments. However, if funds are limited and only one of the two projects can be funded, then the two projects must be compared over equal lives. Thus, the residual value of Project I at the end of period 4 is used to equalize the two lives.

 The net present value of the two projects over equal lives indicates that Project I has a higher net present value and would be a superior investment.