Alternative Capital Investments The investment committee of Shield Insurance Co.

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 $646,000. The estimated net cash flows from each project are as follows:

Office Expansion

Server Upgrade

The committee has selected a rate of 12% 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 $213,000.

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.

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.

3. The net present value of the two projects over equal lives indicates that the Selectoffice expansionserver upgradeItem 13 has a higher net present value and would be a superior investment.

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 $646,000. The estimated net cash flows from each project are as follows:

Net Cash Flow Year     

Office Expansion

    

Server Upgrade

1 $170,000 $224,000 2 170,000 224,000 3 170,000 224,000 4 170,000 224,000 5 170,000 6 170,000

The committee has selected a rate of 12% 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 $213,000.

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 Selectoffice expansionserver upgradeItem 13 has a higher net present value and would be a superior investment.

Explanation / Answer

1 Office Expansion Server Upgrade Present value of annual net cash flows 698870 680288 Less amount to be invested 646000 646000 Net present value 52870 34288 2 Office Expansion Server Upgrade Present value of annual net cash flows 651758 680288 Less amount to be invested 646000 646000 Net present value 5758 34288 3 The net present value of the two projects over equal lives indicates that the server upgrade has a higher net present value and would be a superior investment.

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