Question

Daryl Kearns saved $200,000 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 $190,000. The following table presents the estimated cash inflows for the two alternatives:

	Year 1			Year 2			Year 3			Year 4
Opportunity #1	$	55,705		$	58,880		$	78,900		$	101,350
Opportunity #2		102,600			109,150			18,000			14,600

Mr. Kearns decides to use his past average return on mutual fund investments as the discount rate; it is 12 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?

Answer 1

a)	Net Present Value Approach
			Opportunity 1		Opportunity 2
	Year	PVF @ 12%	Cash Infow	PV	Cash Infow	PV
	0	1	$ -1,90,000.00	$ -1,90,000.00	$ -1,90,000.00	$ -1,90,000.00
	1	0.89286	$      55,705.00	$      49,736.77	$ 1,02,600.00	$      91,607.44
	2	0.79719	$      58,880.00	$      46,938.55	$ 1,09,150.00	$      87,013.29
	3	0.71178	$      78,900.00	$      56,159.44	$      18,000.00	$      12,812.04
	4	0.63552	$ 1,01,350.00	$      64,409.95	$      14,600.00	$        9,278.59
	Net Present Value			$      27,244.71		$      10,711.36
	As the NPV of opportunity 1 is higher, Mr. Kearns shall go with
	this one only.

b)		Opportunity 1		Opportunity 2
			Cumulative		Cumulative
	Year	Inflow	Inflow	Inflow	Inflow
	1	$    55,705.00	$    55,705.00	$ 1,02,600.00	$ 1,02,600.00
	2	$    58,880.00	$ 1,14,585.00	$ 1,09,150.00	$ 2,11,750.00
	3	$    78,900.00	$ 1,93,485.00	$    18,000.00	$ 2,29,750.00
	4	$ 1,01,350.00	$ 2,94,835.00	$    14,600.00	$ 2,44,350.00

Payback period for Opportunity 1				=	2 + [($ 190000 - $ 114585) / $ 78900]
				=	2.96	years
Payback period for Opportunity 2				=	1 + [($ 190000 - $ 102600) / $ 109150]
				=	1.80	years
As the payback period of Opportunity 2 is less, Mr. Kearns shall go with this option.

Please let me know if you find anything incorrect. Thank you