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Calculating the Net Present Value and Payback Period of an Opportunity

Leona Rosato just won a lottery and received a cash award of \$400,000 net of tax. She is 61 years old and would like to retire in four years. Weighing this important fact, she was found two possible investments, both of which require an immediate cash payment of \$ 320,000. The expected cash inflows from the two investments opportunities are follows.

Year 1 Year 2 Year 3 Year 4
Opportunity A \$182,400 \$104,000 \$59,200 \$67,200
Opportunity B 45,600 53,600 118,400 270,400

Ms. Rosato decided that her required rate of return should be 10 percent.

Required

- Compute the net present value of each opportunity. Which should Ms. Rosato choose based on the net present value approach?
- Compute the payback period for each opportunity. Which should Ms. Rosato choose based on the payback approach?
- Compare the net present value approach with the payback approach. Which method is better in the given circumstances?

Solution Preview

- Compute the net present value of each opportunity. Which should Ms. Rosato choose based on the net present value approach?

Opportunity A NPV = -320000+182400/(1+10%)^1+104000/(1+10%)^2+59200/(1+10%)^3+67200/(1+10%)^4= \$22,144.94

Opportunity B NPV = -320000+45600/(1+10%)^1+53600/(1+10%)^2+118400/(1+10%)^3+270400/(1+10%)^4= \$ 39,394.58

Opportunity B has higher NPV ...

Solution Summary

The solution calculates the net present value and payback period of an opportunity.

\$2.19