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 $187,000. The following table presents the estimated cash inflows for the two alternatives:

  

	Year 1			Year 2			Year 3			Year 4
Opportunity #1	$	55,630		$	58,940		$	78,830		$	101,320
Opportunity #2		102,800			109,200			18,100			14,400

  

Mr. Kearns decides to use his past average return on mutual fund investments as the discount rate; it is 9 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?

Compute the net present value of each opportunity. Which should Mr. Kearns adopt based on the net present value approach? (Round your intermediate calculations and final answer to two decimal places.)

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

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

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

Answer 1

Solution 1:

Computation of Net present value
Year	Opportunity 1	Opportunity 2	PV factor @ 9%	PV of Opportunity 1	PV of Opportunity 2
1	55,630	1,02,800	0.917430	51,036.63	94,311.80
2	58,940	1,09,200	0.841680	49,608.62	91,911.46
3	78,830	18,100	0.772180	60,870.95	13,976.46
4	1,01,320	14,400	0.708420	71,777.11	10,201.25
			Total	2,33,293.31	2,10,400.97
			Initial outflow	1,87,000.00	1,87,000.00
			Net present value	46,293.31	23,400.97

Opportunity 1 should be adopted as it higher Net present value.

Solution 2:

Computation of Cumulative Cash Inflows
Year	Opportunity 1	Cumulative cash flows of Opportunity 1	Opportunity 2	Cumulative cash flows of Opportunity 2
1	55,630	55,630	1,02,800	1,02,800
2	58,940	1,14,570	1,09,200	2,12,000
3	78,830	1,93,400	18,100	2,30,100
4	1,01,320	2,94,720	14,400	2,44,500

Payback period Opportunity 1 = 2 + ($187000 - $114570)/ 78830 = 2 + 0.92 = 2.92 years

Payback period Opportunity 2 = 1 + ($187000 - $102800)/ 109200 = 1 + 0.77 = 1.77 years

Opportunity 2 should be adopted as it has lowest payback period.