The CFO of Advo Corporation is considering two investment opportunities. The exp

Question

The CFO of Advo Corporation is considering two investment opportunities. The expected future cash inflows for each opportunity follow: w w w . m h h e . c o m / e d m o n d s 2 0 1 1 Year 1 Year 2 Year 3 Year 4 Project 1 $144,000 $147,000 $160,000 $178,000 Project 2 204,000 199,000 114,000 112,000 Both investments require an initial payment of $400,000. Advo’s desired rate of return is 16 percent. Required a. Compute the net present value of each project. Which project should Advo adopt based on the net present value approach? b. Use the incremental revenue summation method to compute the payback period for each project. Which project should Advo adopt based on the payback approach? edm10890_ch10_442-483.indd Page 463 7/24/10 3:45 PM user-f497 /Volumes/105/PHS00142/work/indd O R O S C O , J R . , R O B E R T 2 9 2 0 B U 464 Chapter 10 Project 2 Cash Inflows Table Factor* Present Value Year 1 $204,000 3 0.862069 5 $175,862 Year 2 199,000 3 0.743163 5 147,889 Year 3 114,000 3 0.640658 5 73,035 Year 4 112,000 3 0.552291 5 61,857 PV of cash inflows 458,643 Cost of investment (400,000) Net present value $ 58,643 *Table 1, n 5 1 through 4, r 5 16% Solution to Requirement a Project 1 Cash Inflows Table Factor* Present Value Year 1 $144,000 3 0.862069 5 $124,138 Year 2 147,000 3 0.743163 5 109,245 Year 3 160,000 3 0.640658 5 102,505 Year 4 178,000 3 0.552291 5 98,308 PV of cash inflows 434,196 Cost of investment (400,000) Net present value $ 34,196 *Table 1, n 5 1 through 4, r 5 16% Advo should adopt Project 2 since it has a greater net present value. Solution to Requirement b Cash Inflows Project 1 Project 2 Year 1 $144,000 $204,000 Year 2 147,000 199,000 Total $291,000 $403,000 By the end of the second year, Project 2’s cash inflows have more than paid for the cost of the investment. In contrast, Project 1 still falls short of investment recovery by $109,000 ($400,000 2 $291,000). Advo should adopt Project 2 since it has a shorter payback period.

Explanation / Answer

Table shows the working of NPV-Npv is calculated 1/1.16 for the year one and result is divided by 1.16 in next year and continued so on for next consecutive.

Project-1 NPV@16% of project-1 NPV@16% NPV @16% of project-2 Project-2 -400000 -400000 1 -400000 -400000 144000 124128 0.862 175848 204000 147000 109221 0.743 147857 199000 160000 102560 0.641 73074 114000 178000 98434 0.553 61936 112000 229000 34343 TOTAL 58715 229000

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