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 $490,000. The estimated net cash flows from each project are as follows:

		Net Cash Flows
Year		Office Expansion		Servers
1		$125,000		$165,000
2		125,000		165,000
3		125,000		165,000
4		125,000		165,000
5		125,000
6		125,000

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, the office expansion's residual value would be $180,000.

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	3.353	2.991
6	4.917	4.355	4.111	3.785	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:

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   has a higher net present value and would be a superior investment.

Answer 1

a	Net present value
	Office expansion
	Present value inflow = annual cash flow x annuity factor
	that is 125000 x 4.111
	=513875
	Add: Present value of residual value at year 4
	that is 180000x .636
	= 114480
	Total present value of inflow = 114480+513875
	=628355
	NPV = Outflow - Present value of inflow
	that is 628355-490000
	=138355
	Servers
	Present value inflow = annual cash flow x annuity factor
	that is 165000 x 3.037
	=501105
	NPV = Outflow - Present value of inflow
	that is 501105-490000
	=11105
b	Office expansion with 4 year life
	Present value inflow = annual cash flow x annuity factor
	that is 125000 x 3.037
	=379625
	Add: Present value of residual value at year 4
	that is 180000x .636
	=114480
	Total present value of inflow = 114480+379625
	=494105
	NPV = Outflow - Present value of inflow
	that is 494105-490000
	=4105
c	The net present value of the two projects over equal lives indicates that the Server upgradation  has a higher net present value and would be a superior investment.