Question

He investment committee of Sentry 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 $490,000. The estimated net cash flows from each project are as follows:
Net Cash Flows
Year Office Expansion Servers
1 $125,000 $165,000
2 $125,000 $165,000
3 $125,000 $165,000
4 $125,000 $165,000
5 $125,000
6 $125,000

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 $180,000.

Required:

1. For each project, compute the net present value. (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.

Office Expansion Server Upgrade
Present value of net cash flow total $ $
Less: Amount to be invested $ $
Net present value $ $

Answer 1

Answer:

1.

Net present value for Office expansion: $23,926

Net present value of Servers: $11,163

2.

Net present value for Office expansion: $4,062

Net present value of Servers: $11,163

Explanation:

1.

* Net present value for Office expansion:

Net present value = Present value of the 6 equal cashflow - Initial investment = (125,000/12%) x [1-1.12^(-6)] - 490,000 = $23,926;

* Net present value of Servers:

Net present value = Present value of the 4 equal cashflow - Initial investment = (165,000/12%) x [1-1.12^(-4)] - 490,000 = $11,163

2.

* Net present value of Servers is unchanged which is $11,163

* Net present value for Office expansion: Present value of the 4 equal cashflow + Present value of residual value in 4 years time - Initial investment = (125,000/12%) x [1-1.12^(-4)] + (180,000/1.12^4) - 490,000 = $4,062