Question

Daryl Kearns saved $260,000 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 $187,500. The following table presents the estimated cash inflows for the two alternatives:

Year 1 Year 2 Year 3 Year 4

Opportunity #1 $ 55,690 $ 58,770 $ 78,780 $ 101,410

Opportunity #2 103,100 109,300 18,200 15,600

  

Mr. Kearns decides to use his past average return on mutual fund investments as the discount rate; it is 10 percent. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.)

Required

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

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

Answer 1

1)

NPV = Present value of cash inflows - present value of cash outflows

NPV of oppurtunity 1 = -187,500 + 55,690 / ( 1 + 0.1)¹ + 58,770 / ( 1 + 0.1)² + 78,780 / ( 1 + 0.1)³ + 101,410 / ( 1 + 0.1)⁴

NPV of oppurtunity 1 = 40,150.495

NPV of oppurtunit 2 = -187,500 + 103,100 / ( 1 + 0.1)¹ + 109,300 / ( 1 + 0.1)² + 18,200 / ( 1 + 0.1)³ + 15,600 / ( 1 + 0.1)⁴

NPV of oppurtunity 2 = 20,886.79

Based on the NPV approach, Mr. Kearns should select oppurtunity 1 as it has the highest NPV.

2)

Payback period:

Oppurtunity 1:

Cumulative cash flow for year 0 = -187,500

Cumulative cash flow for year 1 = -187,500 + 55,690 = -131,810

Cumulative cash flow for year 2 = -131,810 + 58,770 = -73,040

Cumulative cash flow for year 3 = -73,040 + 78,780 = 5,740

73,040 / 78,780 = 0.92

Payback period of oppurtunity 1 = 2 + 0.92 = 2.92 years

Oppurtunity 2:

Cumulative cash flow for year 0 = -187,500

Cumulative cash flow for year 1 = -187,500 + 103,100 = -84,400

Cumulative cash flow for year 2 = -84,400 + 109,300 = 24,900

84,400 / 109,300 = 0.77

Payback for oppurtunity 2 = 1 + 0.77 = 1.77

Based on the payback approach. Mr. Kearns should choose oppurtunity 2 as it has a lesser payabck period.