The CFO of Advo Corporation is considering two investment opportunties. The expe

Question

The CFO of Advo Corporation is considering two investment opportunties. The expected future cash inflows for each opportunity follow:

, 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 initital of $400,000. dvo's desired rate of return is 16 percent.

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 pn the payback approach?

1) What is meant by the expression, time value of money?

2) Why should all capital investment proposals include time value of money (present value) calculations of future cash flows that are to be received from the alternative investments?

Explanation / Answer

Req A Project 1 Year Cash Inflows x DF at 16%* = Present Value 1 $144,000 0.862069            124,137.93 2           147,000 0.743163            109,244.95 3           160,000 0.640658            102,505.23 4           178,000 0.552291              98,307.82 Present value of cash inflows            434,195.92 Cost of investment               (400,000) Net Present value              34,195.92 *=1.16^-1 = 0.862069 Project 2 Year Cash Inflows x DF at 16%* = Present Value 1 $204,000 0.862069            175,862.07 2           199,000 0.743163            147,889.42 3           114,000 0.640658              73,034.97 4           112,000 0.552291              61,856.60 Present value of cash inflows            458,643.06 Cost of investment               (400,000) Net Present value              58,643.06 Project 2 having greater NPV , should be selected Req B Cash Inflows Project 1 Project 2 Year 1 $144,000 $204,000 Year 2          147,000           199,000 $291,000 $403,000 By the end of second year project 2 has crossed its initial investment of 400000 But project 1 has falls short of (400000-291000) 109000, so project 2 should be selected Based on Payback 1 Time value of money concepts says that money available today in hands have more value than money available in future, its due to the effect of inflation and interest factor. 2 All capital investment proposal include time value of money since cash flows from alternative projects might have different values and to make them comparable, its necessary to discount their cash inflows for arriving at present value.

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