Alternative Capital Investments The investment committee of Shield Insurance Co.
ID: 2425901 • Letter: A
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 $1,239,000. The estimated net cash flows from each project are as follows:
Net Cash Flow
Year
Office Expansion
Server Upgrade
1
$346,000
$457,000
2
346,000
457,000
3
346,000
457,000
4
346,000
457,000
5
346,000
6
346,000
The committee has selected a rate of 15% 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 $433,000.
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 _________________ has a higher net present value and would be a superior investment.
Net Cash Flow
Year
Office Expansion
Server Upgrade
1
$346,000
$457,000
2
346,000
457,000
3
346,000
457,000
4
346,000
457,000
5
346,000
6
346,000
Explanation / Answer
The Net present value of an investment proposal is defined as the sum of the Present Values of all future cash inflows less the sum of the Present Values of all cash outflows associated with the proposal.
If NPV > 0 - Accept the project. Surplus over and above the cut-off rate is obtained.
If NPV = 0 - Project generates cash flows at a rate just equal to the cost of capital. Hence, it may be accepted or rejected. This constitutes an Indifference point.
If NPV < 0 - Reject the project. The Project does not provide returns even equivalent to the cut-off rate.
1. Computation of net present value by using the present value of an annuity of $1 table
Since the NPV of the Office Expansion is more it should be accepted than Server Expansion as per the present value of an annuity of $1 table.
2. Computation of net present value by using the present value of of $1 table by assuming that the office expansion is adjusted to a four-year life for purposes of analysis
3. The net present value of the two projects over equal lives indicates that the Net Present Value of the Server Upgrade has a higher net present value and would be a superior investment.
OFFICE EXPANSION SERVER UPGRADE YEAR DICOUNTED RATE 15% NET CASH FLOWS $ DISCOUNTED CASH FLOWS $ NET CASH FLOWS $ DISCOUNTED CASH FLOWS $ 1 0.87 346000 301020 457000 397590 2 1.626 346000 562596 457000 743082 3 2.283 346000 789918 457000 1043331 4 2.855 779000 2224045 457000 1304735 5 3.352 346000 1159792 6 3.784 346000 1309264 PRESENT VALUE OF ANNUAL NET CASH FLOWS 6346635 3488738 LESS: AMOUNT TO BE INVESTED 1239000 1239000 NET PRESENT VALUE $ 5107635 2249738Related Questions
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