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

  

	Year 1			Year 2			Year 3			Year 4
Opportunity #1	$	55,725		$	58,930		$	78,770		$	101,270
Opportunity #2		103,400			109,650			18,200			14,300

  

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?

	Net Present Value
Opportunity 1
Opportunity 2
Which opportunity should be chosen?

	Payback Period
Opportunity 1
Opportunity 2
Which opportunity should be chosen?

Answer 1

Part A: Calculation of Net Present Value of both opportunities:

Year	Cash Flow	Present Value Factor @ 8%	Discounted Cash Flow
Opportunity 1	Opportunity 2	Opportunity 1	Opportunity 2
0	$    -1,90,000.00	$    -1,90,000.00	1.0000	$    -1,90,000.00	$    -1,90,000.00
1	$          55,725.00	$      1,03,400.00	0.9259	$          51,597.22	$          95,740.74
2	$          58,930.00	$      1,09,650.00	0.8573	$          50,522.98	$          94,007.20
3	$          78,770.00	$          18,200.00	0.7938	$          62,530.17	$          14,447.75
4	$      1,01,270.00	$          14,300.00	0.7350	$          74,436.47	$          10,510.93
NET PRESENT VALUE	$         49,086.84	$         24,706.62

Since the Net Present Value of Opportunity A is higher, it is recommended to adopt Opportunity A.

Part B: Calculation of Payback period of both opportunities:

Payback period is the period within which the investment has been recovered. It doesn't consider Interest rate and hence discounted cash flows are not required.

Payback Period of Opportunity A

Year	Investment due at beginning of year	Cash Flow	Investment due at end of year
1	$                  1,90,000.00	$          55,725.00	$                  1,34,275.00
2	$                  1,34,275.00	$          58,930.00	$                     75,345.00
3	$                     75,345.00	$          78,770.00	$                                      -

Payback period of A = 2 (+) 75345/78770 years

= 2.96 years

Payback Period of Opportunity B

Year	Investment due at beginning of year	Cash Flow	Investment due at end of year
1	$                  1,90,000.00	$      1,03,400.00	$                     86,600.00
2	$                     86,600.00	$      1,09,650.00	$                                      -

Payback period of B = 1 (+) 86600/109650 years

= 1.79 years

Since the payback period of Opportunity B is low, it is suggested to adopt Opportunity B