Daryl Kearns saved $240,000 during the 30 years that he worked for a major corpo

Question

Daryl Kearns saved $240,000 during the 30 years that he worked for a major corporation. Now he has retired at the age of 60 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 $160,000. The following table presents the estimated cash inflows for the two alternatives: Year 1 Year 2 Year 3 Year 4 Opportunity #1 $ 44,000 $ 47,200 $ 63,200 $ 80,000 Opportunity #2 81,600 86,400 16,000 16,000 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 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?

Explanation / Answer

Answer 1. Year 0 1 2 3 4 Investment 1 Cash Inflow         (160,000)          44,000                47,200          63,200          80,000 PV Factor - 8%           1.00000       0.92593             0.85734       0.79383       0.73503 Present Value         (160,000)          40,741                40,466          50,170          58,802 NPV              30,180 Investment 2 Cash Inflow         (160,000)          81,600                86,400          16,000          16,000 PV Factor - 12%           1.00000       0.92593             0.85734       0.79383       0.73503 Present Value         (160,000)          75,556                74,074          12,701          11,760 NPV              14,092 Investment 1- Highest NPV Answer 2. Payback period - Investment 1 Year Intial Invetments Cash Inflow Accumulated Net Cash Inflow 0           160,000                   -                           -   1          44,000                44,000 2          47,200                91,200 3          63,200             154,400 4          80,000             234,400 Payback period = 3 Years + (5,600 / 80,000 x 1 Year) Payback period = 3 Years + 0.07 Payback period = 3.07 Years (Approx.) Payback period - Investment 2 Year Intial Invetments Cash Inflow Accumulated Net Cash Inflow 0           160,000                   -                           -   1          81,600                81,600 2          86,400             168,000 3          16,000             184,000 4          16,000             200,000 Payback period = 1 Years + (78,400 / 86,400 x 1 Year) Payback period = 1 Years + 0.91 Payback period = 1.91 Years (Approx.) Investment 2- Lower Payback Period

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