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Accounting

27th Edition
WARREN + 5 others
ISBN: 9781337272094

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Section
BuyFindarrow_forward

Accounting

27th Edition
WARREN + 5 others
ISBN: 9781337272094
Textbook Problem

Alternative capital investments

 The 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.

Instructions

 1.    For each project, compute the net present value. Use the present value of an annuity of $1 table appearing in this chapter (Exhibit 5). (Ignore the unequal lives of the projects.)

 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 appearing in this chapter (Exhibit 2).

 3.    Prepare a report to the investment committee,    givingyour adviceontherelative merits of the two projects.

1.

To determine

Net present value method

Net present value method is the method which is used to compare the initial cash outflow of investment with the present value of its cash inflows. In the net present value, the interest rate is determined by the business, based on the net income from the investment, and it is also called as the discounted cash flow method.

To determine: The net present value of each investment, using the present value of $1 table in Exhibit 5, ignoring the unequal lives of the project.

Explanation

Calculation of the net present value of Office Expansion is as follows:

S Insurance Company
Net Present Value of Office Expansion
Particulars Amount In $ (except present value of annuity)
Annual net cash flow  $125,000
Present value of annuity of $1 at 12% for 6 years (Exhibit 5) 4.111
Present Value of annual net cash flow $513,875
Less: Amount to be invested -$490,000
Annual net cash flow  $23,875

2.

To determine

To calculate: The net present value of each project assuming the office expansion is adjusted to a four year life, using the present value of $1 table in Exhibit 2.

3.

To determine

To prepare: The report the merits of the two investments to the capital investment committee.

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