Question

Daryl Kearns saved $270,000 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 $186,500. The following table presents the estimated cash inflows for the two alternatives:

	Year 1			Year 2			Year 3			Year 4
Opportunity #1	$	55,700		$	58,820		$	78,750		$	101,340
Opportunity #2		102,600			109,400			17,800			14,200

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

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

B) 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 years Opportunity 2 years Which opportunity should be chosen?

Answer 1

Solution A:

Computation of NPV
			Opportunity 1		Opportunity 2
Particulars	Period	PV Factor (12%)	Amount	Present Value	Amount	Present Value
Cash outflows:
Initial investment	0	1	$186,500	$186,500	$186,500	$186,500
Present Value of Cash outflows (A)				$186,500		$186,500
Cash Inflows
Year 1	1	0.89286	$55,700	$49,732	$102,600	$91,607
Year 2	2	0.79719	$58,820	$46,891	$109,400	$87,213
Year 3	3	0.71178	$78,750	$56,053	$17,800	$12,670
Year 4	4	0.63552	$101,340	$64,403	$14,200	$9,024
Present Value of Cash Inflows (B)				$217,079		$200,514
Net Present Value (NPV) (B-A)				$30,579		$14,014

Opportunity 1 should be chosen as its having higher NPV

Solution B:

Computation of Cumulative Cash flows
Period	Opporunity 1		Opporunity 2
	Cash inflows	Cumulative Cash Inflows	Cash inflows	Cumulative Cash Inflows
1	$55,700	$55,700.00	$102,600	$102,600.00
2	$58,820	$114,520.00	$109,400	$212,000.00
3	$78,750	$193,270.00	$17,800	$229,800.00
4	$101,340	$294,610.00	$14,200	$244,000.00

Payback period:

Opportunity 1 = 2 years + ($186,500 - $114,520) / $78,750 = 2.91 years

Opportunity 2 = 1 year + ($186,500 - $102,600) / $109,400

= 1.77 years

Opportunity 2 should be chosen on the basis of payback period.