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 $1,281,000. The estimated net cash flows from each project are as follows: Net Cash Flow Year Office Expansion Server Upgrade 1 $336,000 $444,000 2 336,000 444,000 3 336,000 444,000 4 336,000 444,000 5 336,000 6 336,000 The committee has selected a rate of 12% 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 $420,000. Present Value of $1 at Compound Interest Year 6% 10% 12% 15% 20% 1 0.943 0.909 0.893 0.870 0.833 2 0.890 0.826 0.797 0.756 0.694 3 0.840 0.751 0.712 0.658 0.579 4 0.792 0.683 0.636 0.572 0.482 5 0.747 0.621 0.567 0.497 0.402 6 0.705 0.564 0.507 0.432 0.335 7 0.665 0.513 0.452 0.376 0.279 8 0.627 0.467 0.404 0.327 0.233 9 0.592 0.424 0.361 0.284 0.194 10 0.558 0.386 0.322 0.247 0.162 Present Value of an Annuity of $1 at Compound Interest Year 6% 10% 12% 15% 20% 1 0.943 0.909 0.893 0.870 0.833 2 1.833 1.736 1.690 1.626 1.528 3 2.673 2.487 2.402 2.283 2.106 4 3.465 3.170 3.037 2.855 2.589 5 4.212 3.791 3.605 3.352 2.991 6 4.917 4.355 4.111 3.784 3.326 7 5.582 4.868 4.564 4.160 3.605 8 6.210 5.335 4.968 4.487 3.837 9 6.802 5.759 5.328 4.772 4.031 10 7.360 6.145 5.650 5.019 4.192 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. Office Expansion Server Upgrade Present value of annual net cash flows $ $ Less amount to be invested $ $ Net present value $ $ 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. Office Expansion Server Upgrade Present value of net cash flow total $ $ Less amount to be invested $ $ Net present value $ $ 3. The net present value of the two projects over equal lives indicates that the Selectoffice expansionserver upgrade has a higher net present value and would be a superior investment.

Explanation / Answer

Office Expansion Server Upgrade Year -1281000 -1281000 Initial Investment 1 $ 336,000 $ 444,000 2 336,000 444,000 3 336,000 444,000 4 336,000 444,000 5 336,000 6 336,000 Present value of annual net cash flows $ 1,381,296 $ 1,348,428 (336,000*PVAF @ 12% for 6 years (444,000*PVAF @ 12% for 4 years Less amount to be invested $ 1,281,000 Less amount to be invested $ 1,281,000 Net present value $     100,296 Net present value $       67,428 Present value of net cash flows total 1020432 (336,000*PVAF @ 12% for 4 years 267120 (420,000*PVF @ 12% for 4 years Less amount to be invested $ 1,281,000 Net present value $          6,552 server upgrade has higher NPV over equal lives.and would be a superior investent

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