Mr X saved $800,000 during the 25 years that he worked for a major corporation.

Question

Mr X saved $800,000 during the 25 years that he worked for a major corporation. Now he has retired at the age of 50 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 $700,000. The following table presents the estimated cash inflows for the two alternatives.

    Year 1     Year 2     Year 3     Year 4
Opportunity #1     $210,000        $210,000        $287,000        $378,000  
Opportunity #2     399,000        406,000        63,000        63,000  


a.).
Mr. X decides to use his past average return on mutual fund investments as the discount rate; it is 8 percent.

Opportunity 1    
Opportunity 2

(b)    

Compute the payback period for each opportunity. Which should Mr. X adopt based on the payback approach?
Opportunity 1     xx years     
Opportunity 2    xx years  

Explanation / Answer

a) NPV for opportunity 1 = -700000 + 210000/1.08 + 210000/1.088^2 + 287000/1.08^3 + 378000/1.08^4 = 177518.8

NPV for opportunity 2= -700000 + 399000/1.08 + 406000/1.088^2 + 63000/1.08^3 + 63000/1.08^4 = 108742.2

should go for opportunity 1 on NPV criteria

b. payback period for opportunity 1 = 2.98 years

payback period for opportunity 2 = 1.74 years

Mr. X adopt opportunity 1 based on the payback approach

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