Alternative Capital Investments The investment committee of Shield Insurance Co.

Question

Alternative Capital Investments

The investment committee of Shield Insurance Co. is evaluating two projects, office expansion and upgrade to computer servers. The projects have different useful lives, but each requires an investment of $1,242,000. The estimated net cash flows from each project are as follows:

Office Expansion

Server Upgrade

The committee has selected a rate of 15% for purposes of net present value analysis. It also estimates that the residual value at the end of each project's useful life is $0, but at the end of the fourth year, the office expansion's residual value would be $434,000.

Required:

If required, use the minus sign to indicate a negative net present value.

1. For each project, compute the net present value. Use the present value of an annuity of $1 table above. Ignore the unequal lives of the projects. If required, round to the nearest dollar.

2. For each project, compute the net present value, assuming that the office expansion is adjusted to a four-year life for purposes of analysis. Use the present value of $1 table above.

3. The net present value of the two projects over equal lives indicates that the Selectoffice expansionserver upgradeItem 13  has a higher net present value and would be a superior investment.

Net Cash Flow Year     

Office Expansion

    

Server Upgrade

1 $347,000 $458,000 2 347,000 458,000 3 347,000 458,000 4 347,000 458,000 5 347,000 6 347,000

Explanation / Answer

Ans

Ans 1 Office Expansion Server Upgrade Initial Investment -12,42,000 -12,42,000 Annual Cash inflows             3,47,000.00                       4,58,000.00 PVAF @15% 3.784 2.855 Present Value of cash inflows          13,13,048.00                     13,07,590.00 NPV                71,048.00                           65,590.00 Ans 2 a Office Expansion Server Upgrade Initial Investment -12,42,000 -12,42,000 Annual Cash inflows             3,47,000.00                       4,58,000.00 PVAF @15% 2.855 2.855 Present Value of cash inflows             9,90,685.00                     13,07,590.00 Residual Value             4,34,000.00 DF@15%                           0.57 Present Value of Residual Value             2,48,248.00 PV of cash inflows          12,38,933.00 NPV                 -3,067.00                           65,590.00 Ans 2 b Incase of life disparity ,bettor mtehod would be to find out the equated annual benefit. Office Expansion Server Upgrade NPV                71,048.00                           65,590.00 PVAF 3.784 2.855 EAB                18,775.90                           22,973.73 Ans 3 EAB is better incase of Server upgrade.

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