Question

Your company has two alternative opportunities, each requiring your entire capital investment budget of $325,000. Alternative A will return $390,000 at the end of one year; alternative B will return $216,000 at the end of each of the first two years. Which alternative should you recommend on the basis of

(a) net present worth if the required rate of return was 10%?

(b) When would/ wouldn’t this be an appropriate managerial decision-making tool?

Answer 1

a) Net present worth of Alternative A=PV of Cash Flows-Initial Investment =390000/(1+10%)-325000 =29545.45
Net present worth of Alternative B=PV of Cash Flows-Initial Investment =216000/(1+10%)+216000/(1+10%)^2-325000 =49876.03

b) This would be an appropriate managerial decision-making tool when there is no change in discount rate . When Discount rate increases then alternative A might be appropriate. This technique would be inappropriate when discount rate is not known or when probability of future cash flow is low.